Tiering in the auto sector is poised to shift, Lehman Brothers predicts. Some nonprime and subprime auto deals should start trading tighter relative to prime paper, as financially struggling U.S. automakers force ABS investors to re-evaluate tiering in the sector.
The expected shuffle represents a significant change in the retail auto ABS market.
Traditionally, auto issuers have fallen into two distinct categories: The prime issuers tended to be large investment-grade corporates, captive finance companies or banks. The nonprime issuers were typically smaller independent finance companies with lower ratings, often below investment grade. This less appealing crowd also had less capitalization and fewer sources of liquidity, making them more reliant on the ABS market for funding.
But for the first time, the demarcation lines between prime and nonprime issuers are blurring. "Tiering used to be straightforward since ABS with lower credit quality collateral was usually issued by lower-rated seller/servicers," Lehman researchers said in their 2006 market forecast. "This is no longer the case."
Both General Motors Corp. and Ford Motor Co., formerly the sector's longtime benchmark issuers, saw their status in the market tumble significantly over the past year, with multiple corporate downgrades from the rating agencies. Ford took the most recent hit, with its Jan. 5 downgrade to BB-' by Standard & Poor's. The agency dunked GM to B' in December.
At the same time, recent acquisitions of nonprime issuers like WFS Financial and Onxy Acceptance Corp. by stronger parent companies is likely to boost their stature in the market. Wachovia Corp. announced in September that it would buy Westcorp and its subsidiary WFS, with the acquisition expected to close this quarter. Capital One Financial Corp. completed its purchase of Onyx in January last year.
Giving tiering another look
Citing such changes, Lehman researchers advise investors to re-evaluate the tiering framework.
Because of the resulting impact on seller/servicer risk, they anticipate an effect on auto ABS spreads. And they believe this change in tiering is here to stay at least for the foreseeable future.
To illustrate the point, they offer analysis of the CARAT and WESTO transactions: GM's CARAT benefits from lower losses and cumulative defaults, but also has lower credit enhancement. The WESTO transactions from WFS, meanwhile, are sometimes wrapped. Both have a history of strong underwriting and stable collateral performance. Triple-A bonds from both shelves are well protected.
"However, given the corporate woes in GM's automotive franchise (B1/B/B+) and Wachovia's (Aa3/A+/AA-) ownership of WFS, which bonds, CARAT or WESTO, are more susceptible to idiosyncratic seller/servicer risk?" Lehman researchers asked. Their answer was CARAT.
Nonprime borrowers are more exposed to adverse macroeconomic conditions such as a slowdown in the housing market or a rise in unemployment, they wrote.
However, their analysis of Lehman's proprietary loan level database indicated that changes in unemployment affect borrower default rates proportionally. They found a 1% rise in unemployment leads to a 20% increase in defaults across the borrower credit.
Subprime transactions wrapped by monoline insurers will have even less credit risk, they pointed out.
Therefore, they concluded, nonprime issuers with a strong seller/servicer profile and stable collateral performance should trade inside weaker prime auto ABS issuers.
The Lehman researchers also said GM- and Ford-sponsored paper lagged other prime issuers by as much as 12 basis points in early May. The two names ended the year more respectably, trading just 5 basis points back. But the researchers caution investors to be wary at that tighter level, and recommend underweighting triple-As from both automakers.
"We have few credit concerns regarding the bonds and do not expect a flood of supply, but spreads could widen if the news from Detroit does not improve," the Lehman report said. "At a concession of just 5 basis points in three-year GM/Ford triple-As, total return investors may lose more in spread widening than they gain in carry in the coming months. In other words, we fear that 5 basis points is inadequate compensation for the elevated headline risk."
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