One of the few positive outcomes of the financial crisis has been the strong performance of consumer ABS, which has become the gift that keeps on giving to investors and will likely continue to do so in 2013 and beyond.
"With the changes in underwriting that have occurred, we think the performance of these deals is quite strong and they'll continue to perform well at least over the near term," said Glenn Bowling, head of ABS credit at Invesco.
Bowling's statement applied specifically to ABS backed by credit card and auto loans, with the much smaller student loan ABS market taking a less certain path.
Even student loan deals, though, are viewed by sell-side and buy-side market participants alike as considerably stronger than before the financial crisis. Indeed, the strength of consumer ABS is drawing investors in droves, creating an issuers'market."Entities that have other points of access to the capital markets - and we've seen this across consumer ABS - have been recently electing to do a greater portion of their funding in the term ABS space because deal execution from both a leverage and spread standpoint has improved," said Steven Moffitt, managing director at Goldman Sachs.
In fact, the strong performance of consumer ABS has drawn nontraditional investors to the market. Google made the news in August when it acknowledged investing in auto ABS, joining new corporate ABS investors including 3M Co. and Automatic Data Processing.
"I'd say the number of inquiries [from corporate treasuries] has picked up in the second half of this year," said John McElravey, head of consumer ABS research at Wells Fargo. "We've been talking to more and more corporate treasury executives who are saying, 'We need to get up to speed on this market because there's less in other areas for us to buy."
Many corporate treasuries have significant cash to put to work, and other investment options such as commercial paper have dwindled. So it is easy to see why they are turning to ABS, and especially to sectors such as credit card and auto ABS.
"The loss rate we just published for our credit-card quality index was 3.6%, which is the lowest level seen since the mid-1990s. It's really unprecedented," said Michael Binz, managing director and head of Standard & Poor's North American ABS ratings group.
Credit card ABS performed strongly throughout the financial crisis and the ensuing recession. In fact, the lack of issuance during that period has actually strengthened credit card trusts as weaker obligors defaulted, originators did not add new accounts, and stronger accounts remained.
Luisa DeGaetano, senior credit officer and manager of credit card ABS at Moody's Investors Service, said those accounts are now very "seasoned" and, after withstanding the great recession, unlikely to default should a macro event, such as an unresolved fiscal cliff, slow the economy next year.
DeGaetano noted that issuers have not added new and potentially problematic accounts to the trusts in recent years, because the slowdown in ABS issuance from before the crisis has made it unnecessary. That could change unexpectedly, she said, but "until issuance really comes back in full force and new card originations get a lot larger, there won't be a need to add accounts to the trusts - that's probably a couple of years down the line."
Credit card ABS issuance is anticipated to approach $40 billion this year, a significant increase over last year's $16 billion but still below the $60 billion in credit card ABS maturing this year, according to S&P, which expects volume to top $40 billion in 2013. The ratings agency anticipates overall consumer ABS to reach $137 billion this year and increase to $149 billion in 2013.
The lower net supply of an asset class that has exhibited strong performance and liquidity has provided issuers with steadily improving funding costs. Moffitt pointed to a the recent reception of an offering of class B notes by Discover Financial Services where Goldman acted as an underwriter; the class priced at LIBOR plus 45 basis points and was upsized to $250 million from $150 million.
"Two years ago, those bonds may not have been distributed in the market, and similar bonds traded in the secondary market at triple-digit spreads, with some shelves as high as 400 or 500 basis points over LIBOR," Moffitt said. "Ultimately, we expect the market to return to a place where the entire investment-grade capital stack is distributable at an attractive cost of funds for Issuers."
Auto-related ABS is expected to reach $100 billion in volume by year-end, with about 20% of issuance in the subprime category, up from $68 billion in 2011. Binz said that S&P anticipates new vehicle sales increasing by 7% in 2013, which could bump up auto-related ABS issuance a bit, perhaps to $105 billion.
Although issuance of subprime auto ABS halted during the crisis, S&P didn't downgrade any tranches during that period, Binz said, adding that subprime collateral has become even stronger since them.
Nevertheless, the subprime auto ABS market has heated up dramatically and attracted a number of new issuers, such as Flagship Credit Acceptance and CIG Financial, that may have experienced management but little track record in terms of loan originations. S&P issued a report in September arguing that the subprime market still has room to grow given the positive changes since the industry's initial boom and severe contraction in the late 1990s. It noted that subprime lenders no longer use gain-on-sale accounting and their centralized servicing today allows for more focused collection efforts and service transfers when necessary.
Moody's takes a less sanguine view; it acknowledges many of the changes in industry practices cited by S&P, but nevertheless feels that many subprime lenders are riskier niche players and that heavy use of securitization can result in excessive lending growth.
"Although it is too early to predict whether today's subprime lending market will deteriorate as it did in the 1990s, the similarities between the early stages then and now suggest that losses will climb as competition intensifies," the report said.
Bowling at Invesco said certain of the larger underwriters in the subprime auto ABS sector, have "modified their underwriting standards on the fringe" by putting loans with somewhat lower credit scores into their pools. The two largest subprime issuers are Santander Consumer USA and AmeriCredit.
"It's not anything measurable, but it's a way for them to pick up market share without significantly impacting the average credit quality of the entire pool," Bowling said. "So there may be some changes in the delinquency and default patterns for the 2012 vintage."
James Grady, managing director at Deutsche Asset Management, said the auto ABS sector's strong performance has prompted market participants to "cash in on the their past success and they're not factoring in the competitive environment that's occurring right now."
Grady said the numerous new entrants are clamoring for the same subprime borrowers, but because the universe of good ones is limited, they are stretching down the credit spectrum to borrowers "who shouldn't be getting access to credit at those [rate] levels." He added that this likely isn't a "2013 or 2014 story, but a 2015 or later story."
On a positive note, Lena Harhaj, an investment analyst at Advantus Capital Management, said that some used car sales and finance companies are underwriting loans more in line with borrowers' ability to make payments. As an example, she noted J.D. Byrider, which provides extended warranties of up to three years or 36,000 miles. "If you can keep the borrower in a functioning car, they're going to continue to make payments on that vehicle," Harhaj said.
Student loan ABS issuance is anticipated to reach $20 billion, a jump over last year's volume with $4 billion of that backed by private-label student loans and the rest guaranteed by the Federal Family Education Loan Program (FFELP), which ended in 2009. S&P anticipates similar volumes in 2013, with slightly higher private-label volumes possible.
Like the other major consumer ABS categories, private student loan ABS issued today has significantly stronger collateral than deals from three or four years ago, with higher FICO scores and more cosigners, and fewer are made to students attending for-profit schools, according to Barbara Lambotte, manager of student loan ABS at Moody's. She noted that the bulk of private-label issuance, totaling about $4 billion, has been by Sallie Mae, with some 501(c)(3) not-for-profits and agencies in states including New Jersey and Massachusetts also issuing.
FFELP loans are 97% guaranteed by the government, and the stronger collateral and deal structures are viewed as making the remaining credit risk negligible for investors. However, Moody's has warned that it may second S&P's August 2011 downgrade of U.S. Treasuries should Congress fail to address the looming fiscal cliff.
That could prohibit some institutional investors from investing in the sector. Bowling said Invesco hasn't purchased many split-rated FFELP deals and going forward, depending on its institutional clients' guidelines, would likely not participate in many new deals, which would be rated 'AA+' by S&P and Moody's.
That risk may already be priced into current FFELP deals, which trade at approximately LIBOR plus 40 basis points, a premium to other consumer ABS sectors.
Binz at S&P noted that student loan FICO scores have increased, in part because students' parents have cosigned the loans. However, the sector - especially the private-label side - faces significant hurdles, particularly if the economy slows and the already difficult job market for graduating students worsens. In addition, Grady noted, legislative changes allowing loan payments to be reduced based on employment status and income level could negatively impact the asset class, and bills aiming to allow student loan debt to be dischargeable in bankruptcy continue to float around Capitol Hill.
