Charge-Off Rate
Definition
The percentage of outstanding receivables that have been written off as uncollectible losses during a given period, typically measured monthly and annualized. Charge-off rate = (Dollar amount charged off) ÷ (Average outstanding receivables) × 12. In consumer ABS (credit cards, auto loans, personal loans), charge-off rates are a critical performance metric and primary trigger for early amortization events.
Why it matters
Charge-off rates directly consume excess spread in consumer ABS, making them the primary indicator of deal health. Unlike CLOs where defaults trigger haircuts in coverage tests, consumer ABS charge-offs immediately reduce cash available for bondholders. When charge-offs exceed excess spread capacity, early amortization triggers, fundamentally changing deal dynamics. Understanding charge-off behavior explains why credit card ABS struggled during 2008-2009 (charge-offs spiked to 10-12% vs. 4-5% normal) while auto ABS performed better (charge-offs peaked at 3-5% vs. 1-2% normal).
Common misconceptions
- •Charge-off rate is not the same as delinquency rate. Delinquency measures accounts past due (leading indicator); charge-offs measure actual losses (lagging indicator). An account typically becomes 60+ days delinquent before being charged off at 180 days.
- •High charge-offs don't automatically mean bondholder losses. If excess spread is sufficient (interest income minus investor coupons minus servicing fees exceeds charge-offs), bondholders continue receiving scheduled payments. Losses occur when charge-offs exceed excess spread for sustained periods.
- •Charge-off rates vary dramatically by product. Credit cards typically run 3-5% in normal times, 8-12% in stress. Auto loans run 1-2% normally, 3-5% in stress. Personal loans can run 5-8% normally, 10-15% in stress. Always compare to product-specific norms, not absolute levels.
- •Charge-off timing matters. Many ABS charge off at 180 days past due, but some structures charge off earlier (120 days) or later (210 days). This affects reported charge-off rates and comparability across deals.
Technical details
Charge-off rate calculation
Monthly Charge-Off Rate = (Charged-Off Amount) ÷ (Average Outstanding Receivables). Annualized: multiply by 12.
Example: Credit card pool with $1 billion average receivables. $30 million charged off in month. Monthly charge-off rate = $30M / $1B = 3.0%. Annualized = 3.0% × 12 = 36% (this would be crisis-level). More realistic: $4M monthly charge-off = 0.4% monthly = 4.8% annualized (normal range).
Three-month average is commonly used in triggers: (Month 1 + Month 2 + Month 3) / 3. This smooths seasonal volatility and prevents false triggers from single-month spikes (e.g., December holiday spending stress).
Charge-off rate triggers and thresholds
Consumer ABS structures typically include charge-off based early amortization triggers:
Credit card ABS: 3-month average charge-off rate exceeds 8-10% (deal-specific). Some deals use absolute triggers (8%) plus relative triggers (2× historical average).
Auto loan ABS: 3-month average exceeds 3-5%. Lower threshold reflects lower normal charge-offs in auto.
Personal loan ABS: 3-month average exceeds 10-12%. Higher threshold reflects higher-risk borrower profile.
Once triggered, trust stops purchasing new receivables and uses collections to pay down bonds. This protects bondholders from continued losses but eliminates equity returns. Recovery requires charge-offs falling back below threshold for sustained period (often 3-6 consecutive months).
Charge-off behavior by product type
Credit cards: Most volatile. Unsecured, revolving credit. Charge-offs spike quickly in recessions (unemployment-driven). Seasonal patterns: higher in January (holiday spending), lower in summer. 2008-2009 peak: 10-12% for prime, 15-20% for subprime.
Auto loans: More stable. Secured by vehicle (recovery mitigates losses). Charge-offs lag economic stress by 6-12 months (borrowers prioritize car payments to avoid repossession). 2008-2009 peak: 4-5% for prime, 8-10% for subprime.
Personal loans: High volatility. Unsecured, often higher-risk borrowers. Charge-offs very sensitive to unemployment. Can spike rapidly (3% to 10% in 6 months during stress). Some structures have monthly charge-off caps (if exceeded, immediate early amortization).
Understanding product-specific dynamics is essential for stress testing ABS portfolios.
Relationship to excess spread
Excess spread absorbs charge-offs before impacting bondholders. The relationship determines deal health:
Strong position: Excess spread 8%, charge-offs 4%. Deal has 4% cushion. Can absorb doubling of charge-offs before bondholder impact.
Stressed position: Excess spread 5%, charge-offs 7%. Negative 2% means reserve accounts or subordination absorbing losses. If sustained, leads to early amortization or principal losses.
Critical position: Excess spread 3%, charge-offs 10%. Severe negative spread. Reserve accounts depleted, subordination eroding, senior bondholders at risk.
This is why excess spread floors (minimum 0-2% for 3 consecutive months) trigger early amortization—once excess spread exhausted, structure vulnerable to bondholder losses.
Recovery rates and net charge-offs
Gross charge-offs vs. net charge-offs: Gross = total charged off. Net = gross minus recoveries. Net charge-offs are what actually impact cash flows.
Recovery rates by product: Credit cards: 10-20% recovery (unsecured, often written off to collection agencies for pennies). Auto loans: 40-60% recovery (secured by vehicle, auction proceeds). Personal loans: 5-15% recovery (unsecured, high-risk borrowers).
Example: $100M auto pool charges off $5M (5% gross charge-off rate). Recovers $2.5M from vehicle sales (50% recovery rate). Net charge-offs = $2.5M = 2.5% net charge-off rate. It's the net charge-off rate that consumes excess spread.
Recovery timing matters: if charge-off occurs in Month 1 but recovery in Month 6, excess spread must absorb full charge-off for 5 months before recovery credit. This creates temporary pressure on excess spread even with high ultimate recoveries.
Leading indicators and predictive analytics
Sophisticated servicers and investors track leading indicators of charge-off spikes:
Delinquency transitions: percentage of 30-day delinquent accounts rolling to 60-day, 60-day to 90-day. Accelerating roll rates predict rising charge-offs 3-6 months ahead.
Credit bureau metrics: percentage of borrowers opening new credit lines, rising utilization rates, increasing inquiries. All signal financial stress before delinquency.
Economic indicators: unemployment rate changes (strongest predictor for credit cards), gas prices (for auto loans), housing prices (for home equity).
Vintage curves: comparing current pool performance to historical vintages originated in similar economic conditions. If current vintage tracking 2008 vintage's curve, suggests stress ahead.
Advanced investors build econometric models combining these indicators to forecast charge-offs 6-12 months forward, enabling proactive portfolio positioning before trigger events.