Video: How Credit Cards Become Bonds

We’ve heard lots about how mortgages get turned into tradeable securities, but they’re not the only thing. No no no, there was far too much Chinese money not able to earn anything on T-bonds for us to let them lie. Credit cards can become asset-backed bonds too. Marketplace’s Paddy Hirsch is back with his whiteboard and dry-erase markers to explain how it works. Video inside.

The Whiteboard: How credit cards become asset-backed bonds [Marketplace]

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  1. Snarkysnake says:

    Better pay attention to ‘ol Paddy here… This is the next financial product that is rigged to explode after it’s creators are out of the picture and sipping margaritas…

  2. johnfrombrooklyn says:

    Riddle me this. Capital One (to use an example) issues a credit card to someone who quickly maxes it out. They miss a couple payments or are late. So Cap One jacks the interest rate up to 32% or so at which point the debt snowballs and the cardholder gets further and further behind until they default. Why doesn’t Cap One just call the cardholder and tell them the card has been shut off, the debt has been capped, and the interest rate has been lowered to a manageable 8 or 9%. Cap One gets a risky customer off its books, perhaps avoids a default, and eventually gets its loan paid off. I grant you this is a worse scenario for Cap One then endless minimum payments at 32% but that’s not going to happen anyway. People are going to start defaulting and Cap One will get nothing.

    • silver-spork says:

      @johnfrombrooklyn: I think the video mostly answers this question. I doubt Dave bought the securities without some guarantee as to the level of interest the account holders would be charged.

      My question is – what exactly is the “equity trench” that he was talking about? Is that an asset that someone can trade or is that just extra money sloshing around in the system?

      • mrgenius says:

        @silver-spork: I think tranche is the word you are looking for.

        [en.wikipedia.org]

      • Anonymous says:

        @silver-spork: So, near as I can tell from this video and other studying I’ve done the equity tranche is another tranche but it could differ significantly from the other tranches (wine glasses) depending on how the CLO is organized. What he seems to be talking about here is a most junior tranche of undefined benefit. Meaning, if you’re in that first AAA tranche you’re most likely to get paid and if you get paid you receive, at most, a pre-determined amount of money. The following tranches probably work the same way where that pre-determined amount goes up according to the risk of monthly (or overall) default on your payment. The last tranche is different because there is no maximum amount set on how much you can receive in a month but you’re also most likely to get nothing.

        But, in the unlikely event the credit card holders all decide to buckle down one month eating ramen and working 70 hours a week to pay off those cards the equity tranche speculators will be sitting pretty.

      • ionerox says:

        @johnfrombrooklyn: Capital One hasn’t lost anything either. The upaid debt is offloaded, so it’s not on their books.
        They still make money for collecting fees from the deal to “service” the accounts (send out bills, collect payments, try to get payments from non-paying customers).

    • SacraBos says:

      @johnfrombrooklyn: Since they’ve “sold” the debt to asset-backed investors, they’ve made their money. This is why you hear about banks that think these “bad” customers are their biggest profit centers – late-fees, over-limit fees, etc are where they make their money. They have already sold the intestest, risk, and/or loss to investors.

  3. ionerox says:

    Pretty much anything with a payment stream can become an Asset Backed Security.

    Some of the ABS deals I’ve seen include: student loans, car loans, lottery payments, film rights, life insurance, timeshares, NYC taxi medallions, payments to farmers to not grow tobacco…

  4. Phexerian says:

    Interesting process. Now I know how credit card companies don’t take any risk at lending you money and possibly why they never cap your credit card; because they can sell the debt off their balance sheets into these BBB and BB “bonds” or securities and still collect monthly fees to turn a profit.

    • artki says:

      @Phexerian: Mostly right. Except when the default rate rises high enough the credit card companies have trouble finding managers who are willing to buy the debt and create the tranches in the first place.

  5. gnortenjones says:

    One thing I’m still a bit confused about:

    Dave buys $1B worth of debt from Citi. In the video example, neither he, nor his investors, actually make any money until all those accounts pay $1B worth of payments, correct? Up until that point, it’s just filling the champagne bottle.

    • Anonymous says:

      @gnortenjones: Not correct. The bottle is filled with champagne already because the investors bought the debt. This is basically “the price of admission.” The monthly, quarterly, yearly income they derive from owning the security comes from the people paying the debt each month. The narrator’s point was that the more people who pay on-time, the more investors get paid. Now, the reason why Citi (in this example) loves this model is because rather than having the receivable on their books and taking the risk you won’t pay, they actually get the $1B. They’re totally happy with that because they can keep lending the money out, get people signed up, and limit their liabilities (the receivables).

    • SacraBos says:

      @gnortenjones: Remember the accrued interest. If you borrow $100, you may pay $1/mo for 180 months (as an example). The investors may get $0.75/mo interest over 180 months, thus creating an income stream than is worth more in 180 months than they paid. Of course, they will probably take $0.50/mo of that payment and invest it in another bond.

      When a “asset” fails, you lose money. Which means, you don’t have that $0.50 to buy more “assets”. Now the bank doesn’t want to loan more money, since they can’t “sell” that debt – thus credit dries up.

      • sonneillon says:

        @SacraBos: Also keep in mind that when the bond matures the principle get’s repaid. So what citi does is takes the bond money and invests in something secure like a TBill. Then collects interest on that TBill and tells the bond holders they can collect the interest on the credit card bills but we get the principle pay offs go to them. Then they take that money and also invests it in those TBills. So they are invest twice as much earning interest on twice as much and risk nothing. If the people don’t pay their bills well the bond holders are SOL. And because this isn’t like a regular bond the investors can’t force citi into bankruptcy for not paying.

  6. fl0722 says:

    A couple questions for anyone who can answer -

    1 – If my credit card is charging me 7% interest and, assuming I have revolving debt, does Dave get all 7%, or does the CC company keep a portion for themselves and leave, say, 5% to Dave?

    I assume that the CC company must get a portion, which is why they’re happy to jack up the interest rates if you miss a payment.

    2 – If I pay off my balance each month, I assume my intra-month debt can’t be sold to Dave. Right?

  7. kwsventures says:

    It is all good until consumers default on the unsecured debt. Then it is not all good.

    • Snarkysnake says:

      @kwsventures:

      Interesting comments,all…But never forget- We have two bankruptcy systems in this country now.Corporate and personal. Corporate failures are just heavily lawyered until somebody gets what meat is left on the bones and generally,the shareholders are wiped out. Bad karma all the way around,but no real suffering because the pain is spread wide.

      Personal bankruptcy (as we are about to see when the unemployment rate shoots up over the next few months) is another matter entirely. It used to be that when you were in over your head,you filed a chapter 13 or if you were really farked,chap 7. But some of the companies that issue cards started noticing that even though they were complicit in helping people hang themselves, the rules needed to be changed again to keep their advantage overwhelming. Enter the Bankruptcy Reform act of 2005. This little gem nailed the door shut for many honest people who got in too deep. Now they have to prove extreme hardship to get out from under their debts,while the companies that issue the cards get bailout funds from the feds. Nice.

      This “reform” has not been stress tested yet with a real recession or faltering economy. Look for lots of pain and suffering as people realize that THEIR get out of jail free card has been torn up…

      • varro says:

        @Snarkysnake: Not necessarily.

        The Bankruptcy Act of 2005 prompted a huge number of people to file for bankruptcy before it went into effect on October 17, 2005; the reduced numbers of filings in 2006 and 2007 were because anyone who was considering filing attempted to file before the laws changed.

        Some people were scared away from bankruptcy because of the perception that it was hard or impossible to do now; in reality, if your income is near or below the median income for your state, you should still be able to file for Chapter 7 or a three-year Chapter 13.

        The credit counseling sessions are not serious obstacles, either.

        I practice consumer bankruptcy law in Oregon, and my caseload has become heavier over the past three months. It still hasn’t gotten to 2003-2004 levels, but is getting there…

        • Snarkysnake says:

          @varro:

          Okay , I hear ya…

          But please answer a couple of questions here.

          I am made to understand that the 2005 act makes discharging unsecured debt all but impossible and providing a “fresh start” with zero debt. In essence,it just exchanges the court for the bill collector to attach wages and ensure repayment over time. Is this correct ?

          I think that counseling aspect of the law is great. Some people need a blueprint to stay out of trouble,no problem there.

          The rationale for the law was the supposed abuse of the system by serial deadbeats and low lifes trying for a free ride. Was / is that your experience ? Or was this just a way for irresponsible lenders to use their relationship with congress to keep their profits up ?

          I would really like to hear a pro’s opinion on this…

          • econobiker says:

            @Snarkysnake:
            That irony needed to be pointed out by someone…

            I posted on a separate thread :”Are these banks and bank-like businesses being bailed out the same ones which got the bankruptcy laws changed a few years back because supposedly “consumers were abusing the bankruptcy process”?

            Apparently yes…

  8. TVarmy says:

    You know, I saw Obama’s Youtube address, and I have to say, I was a bit disappointed. It seemed scripted, when I was hoping he’d be talking off the cuff about his plans for the country. I say we chip in the taxes for a whiteboard, or perhaps he use some book revenue, and he should do what Paddy does to illustrate his plans for the nation.

    Let me make it clear: I am truly excited about Obama, and voted for him in the Primaries and General election. I just love what Paddy does, and it shows what a great medium internet video is.

    • Trickery says:

      @TVarmy: Off-topic much? I don’t see Obama mentioned anywhere until here.

    • econobiker says:

      @TVarmy: Obama is part of the same business funded political party machine that got us into this mess. Real change would have been voting for the alternative political parties which the journalism industry seems to avoid like the plague until just before the elections in “spoiler or not?” stories. The same journalism industry funded by business advertising…hmmmmm…

  9. tailstoo says:

    So people who took risks got paid the most in return for the possibility that they wouldn’t get paid.

    Why is the government giving them money again?