S&P: Auto ABS Ratings Expected to Remain Stable
February 28, 2013
There has been a significant increase in subprime auto lending during the past year as new lenders joined established ones in extending loans to subprime borrowers looking to purchase vehicles. As competition heats up, and after a period of tight underwriting from 2009 through 2011, Standard & Poor’s Ratings Services saw borrower demographics and underwriting standards begin to return to more typical levels in 2012, a trend we expect to continue throughout 2013.
We expected this shift in underwriting after the economy emerged from the recession, when it was difficult for subprime buyers to finance an auto purchase. This recent return to a more typical subprime borrower base is therefore marked by lower credit scores (FICOs) and higher loan-to-value (LTV) ratios than during the tight underwriting of 2009 through 2011.
We expect that this less-conservative underwriting will have a negative impact on subprime auto loan asset-backed securities (ABS) performance, and indeed we are already seeing some signs of slight collateral deterioration. However, certain risk mitigants have lessened the ratings impact.
These include strong payment structures and high credit enhancement levels, which offer additional loss protection. As a result, we do not believe that the expected deterioration in collateral performance in 2013 will result in negative rating actions for subprime auto ABS.
Since we began rating subprime auto loan ABS transactions in 1991, we have not lowered a public rating due to credit deterioration— even during the most recent recession between 2006 and 2008, when losses nearly doubled. We attribute much of this rating stability to strong transaction features, such as sequential payment structures (where the senior notes are paid first), credit-enhancement floors, and performance-related early amortization triggers. These structural features in auto loan ABS transactions typically result in increased credit enhancement levels as the collateral amortizes. For example, in 12 transactions rated in the first half of 2012, hard credit enhancement (credit enhancement from sources other than excess spread) increased by more than 33%, on average, in just the first six months.
Key Issuer- and Deal-Level Analytical Considerations
When we analyze a subprime auto loan transaction, in addition to the collateral features, we review the following originator/servicer characteristics (particularly in the case of issuers that are new to the ABS markets): the financial performance and funding capacity of the originator/servicer, the originator/servicer’s management team, and the underwriting and servicing strategy/capabilities of the originator/servicer. We believe that a financially viable and experienced servicer is key to a subprime portfolio maintaining stable and predictable performance. Generally, a backup servicer can also play an important role in partially mitigating the risk that an originator/servicer will go bankrupt, and as such, many subprime auto loan ABS transactions include backup servicing arrangements.
Furthermore, we also consider the level of management’s financial commitment to the company, as we believe an originator/servicer with a stronger commitment has additional incentive to focus heavily on underwriting and collections.
A review of these variables helps inform our decision as to the highest rating we would assign to a subprime auto loan ABS transaction. For many transactions in this sector, including most transactions we rated in the past few years from first-time issuers, we have rated the senior notes below ‘AAA’.
In addition, we analyze the transaction structure to determine the level of credit protection available to cover potential losses on the collateral. Most, but not all, of the transactions we have seen are sequential-pay structures with subordinate classes of notes, overcollateralization, and a reserve account.
In addition, the reserve account and overcollateralization amounts are typically structured so that the amount does not decrease as the collateral amortizes, thereby providing an enhancement floor to protect against liquidity shortfalls and collateral losses at the tail-end of the transaction. Furthermore, given the subprime nature of the borrower, the yield on the collateral is typically relatively high, leading to higher levels of excess spread (though our analysis assumes lower levels of excess spread to cover losses, as variables such as prepayments and loss timing can influence the level of excess spread available).
Given the short tenor of the notes and the use of credit-enhancement floors, these transactions typically deleverage rapidly. That is, the amount of credit support typically grows as a percent of the amortizing collateral balance. Through cash-flow simulations, we assess whether the enhancement levels are commensurate with the related stressed ratings scenario and whether our ratings will meet our stability criteria in a moderate stress scenario. We have outlined our approach to rating a subprime auto loan ABS in “Standard & Poor’s Explains Its Approach To Rating Subprime Auto Loan ABS Transactions,” published Aug. 29, 2011.
Increased Competition and Its Impact on Collateral Trends