As recessionary economic conditions roil on, market participants can't help but look for the next shoe to drop.
But, while the rising unemployment rate and the higher cost of gas mean increased delinquencies for the auto ABS sector, market participants remain optimistic that solid fundamentals are in place and appetite for auto paper remains healthy.
Taking residential ABS out of the equation, auto ABS is still running about 80% of last year's volume, which is not that bad against the backdrop of where the ABS market is right now, an ABS analyst said.
"Deals that have been brought to the market have been pretty well received," he said, citing Honda Auto Receivables Owner Trust 2008-1, a $1.5 billion transaction that recently priced by way of Barclays Capital and Citigroup Global Markets. Short-term paper priced at one basis point over interpolated Libor while three-year paper priced at 85 basis points over swaps. Banc of America Securities, RBS Greenwich Capital, Wachovia Securities and Credit Suisse were co-managers on the transaction.
Indeed, the capital markets have remained open to auto ABS issuers. Ratings actions to date suggest that the auto ABS market is performing relatively well. Through June 17, there have been two downgrades and 37 upgrades, according to a recent report from Wachovia. For the same period in 2007, there were no downgrades and 93 upgrades.
On June 16, Moody's Investors Service placed a number of auto ABS deals on review for downgrade. However, these actions have more to do with the structure of the transaction than collateral problems, Wachovia analysts said. They explained that many of these deals either had their credit enhancement reduced or their structure changed to include an additional subordinate tranche, which, in turn, causes ratings volatility.
While downgrades are expected to rise as consumers feel the credit pinch, they will not be widespread. "Downgrades of certain subordinate tranches are anticipated, but rating actions will likely be issuer specific rather than entirely broad based," said Kevin Duignan, managing director and head of the U.S. ABS group at Fitch Ratings.
Driving Default Risk
There are two primary drivers of losses in ABS transactions - default risk and loss severity, Duignan said. Default risk is primarily driven by economic factors, with a major driver being the unemployment rate, he said. Recently, the unemployment rate has risen to 5.5%, which will correspond with increases in losses for the sector, according to a recent report from Fitch.
Loss severity is determined by used car prices, which are calculated when a repossessed car is sold at an auction. "Auction prices are driven by what dealers and consumers will pay for a vehicle, and we have seen a steep decline in those values over the past couple of months, particularly in the SUV and truck segment, which makes up a significant portion of most domestic auto ABS manufacturer issuances," Duignan said. "We are seeing that defaults are increasing as the economy struggles, and loss severity is increasing significantly due to higher gas prices and, in particular, its effect on SUV and truck values," he said.
But losses appear to be in line with historical cycles at the beginning of a recessionary economy. "This is a classic consumer behavior at the end of a credit cycle and as we move into a much slower economy," the ABS analyst said.
While 2007 and 2006 default rates in prime autos are higher than in the previous three or four years, the degree of change is not nearly the same as what has been seen in the RMBS sector, sources agreed.
However, wider pricing is still a symptom of current market conditions, including the declining values of cars and much higher gas prices.
"If originators of auto loans and originators of securities have not given the deal that they thought they would to investors, it is reasonable for investors to say, I need some additional yield to compensate me for the extra layer of risk in these securities,'" said William Houlihan, chief financial officer at Sixth Gear Solutions Corp., a new entrant to the auto finance market this month. The company has just begun to originate loans and expects to begin securitizing deals in approximately two years, the average time it takes to collect a sufficient payment history and create a reliable data set.
As issuers originate loans with better terms and when new credit enhancers come into the market to replace financial guarantors that have run into financial troubles - or if they recover from these problems - participants can expect to see the market take a more positive turn, Houlihan said.
"It will probably take a period of years as opposed to a period of months or quarters," he said. "But I hope it will be when we have a large enough loan volume to be thinking about coming into the market."
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