Although auto prepayment speeds are not as interest-rate sensitive as home mortgages, they are still an issue. Segments of certain auto pools will prepay faster than others, based on the issuer (subprime versus prime) and characteristics of the pools. For example, high APR loans will generally prepay at a faster rate than those with lower APRs.
With all else remaining equal, auto loan rates for new and used cars have moved in line with interest rates, albeit trending at a higher level. In August 2000 when interest rates were at 6.5%, new auto loan rates exceeded 7.0%.
As the economy slumped in 2000, the Fed eased interest rates aggressively beginning in January 2001 in an attempt to steer the economy from recession. The fed funds rate was lowered from 6.0% to 1.75% by year-end. As a result of the sluggish economy and the terrorist attacks, industry auto sales fell sharply in the third quarter 2001, leaving auto manufacturers scrambling for a way to sustain sales. The auto companies offered generous incentives, which helped foster a partial recovery in consumer spending at end-2001.
It began with GMAC's roll out of its "Keep America Rolling" interest free (zero-percent) financing program. Consumers viewed the offers as a once-in-a-lifetime opportunity and cut back on other purchases to take advantage of the deals. Rates for new auto loans fell as low as 2.7% at the end of 2001. As such, we have seen an increase in the percentage of subvened loans (i.e. below-market) in recent securitizations. However, auto loan rates have increased to 6.5% in February 2002, as most of the offers have dried up.
Securitizations with a larger percentage of subvened or rates will typically experience slower prepayment rates than those with a higher-weighted average coupon (WAC). For example, GMAC's CARAT 2002-2, which contained 100% subvened loans with a weighted average APR of 2.84%, priced with a prepayment speed of 1.0% ABS. This compares with Ford's FORDO 2002-A, which contained APRs ranging from 0.01% to 29.99% and resulted in a weighted average APR of 6.92%. Ford 2002-A was priced with a higher prepayment speed of 1.5% ABS.
Varied rates of prepayments on receivables with high APRs could affect the yield on a security and may result in losses. Higher prepayment rates of receivables may generate shortfalls in collections, which could be insufficient in covering delinquencies or charge-offs on the receivables or the principal and interest note. However, credit support for auto ABS deals (including the reserve account and excess spread) are sized by the rating agencies to sufficiently protect against potential losses and shortfalls to auto ABS securities.
In sizing credit support levels, rating agencies will examine historical prepayment trends by collateral type, term, and rate to determine the likelihood of voluntary prepayment. Worst-case scenario assumptions are developed to stress the various performance variables, and a prepayment speed assumption is determined to ensure that the loss coverage requirement for a given deal is sized at a sufficient level.
Voluntary prepayments are typically stressed at a high level relative to the historical experience of the pool, since prepayments could accelerate amortization and the payment of principal.
Therefore, when analyzing a pool, rating agencies will separate the pool into subvened and non-subvened sub-pools. When sizing credit enhancement, prepayments for subvened loans are assumed to run at a slower prepayment rate, (typically 0.0% to 0.5% ABS), while non-subvened loans are assumed to prepay at the pricing speed or faster.
Affects of prepayments
on auto ABS
Repayment of principal to investors is dictated by the rate of payments on the underlying auto loans within a given pool. Therefore, prepayments on the underlying loans may cause prepayments on securities, resulting in reinvestment risk to investors.
The final payment date of the securities could be affected and occur before the final scheduled payment date for such a security. Moreover, dependant upon the related interest rate environment, an investor may not able to reinvest the principal at the same rate or higher.
The rate of prepayments may also be caused by the seller/servicer of the underlying receivables pool. If the seller breaches a representation or warranty, which cannot be remedied, then it will be required to purchase the affected receivables from the trust. This will result in a prepayment of the receivables. In addition, auto ABS deals typically have a 10% cleanup call. This means that the servicer has the option to purchase the receivables from the trust when the outstanding principal balance is 10% or less than the total outstanding principal receivables balance.
Therefore, for auto ABS purchased at a discount, the risk is that principal payments are slower than expected. For auto ABS purchased at a premium, the risk is that principal repayments are faster then expected. Both of these scenarios can lead to less-than-anticipated yield on the securities.
Some prime auto lenders have experienced deviations in prepayment trends on their pools. This is partially explained by the record industry vehicle sales in 2000 and 2001. The then-stellar economy (pre-2001) and the increased stock market wealth afforded consumers the ability to trade in their vehicles early, which boosted sales. Also, the interest-free (zero-percent) financings that were offered at the end of last year have impacted prepayment rates. As such, investors have been concerned about the affect on prepayment rates on auto ABS deals.
However, it is important to note that lenders utilise risk-based strategy in assigning APRs on loans. This better matches the APR on the loan to the credit quality of the borrower, so lower credit quality obligors are charged higher rates to offset the greater risk. Also, most of these below-market finance offers have dried up, and the increase in job losses stifles the ability of borrowers to prepay loans, as evidenced by the high level of household debt. Therefore, the up tick in prepayments is likely short-lived, and we do not think it poses any risk of early return of principal.
Prepayments versus Weighted Average Life (WAL)
The weighted average life (WAL) of auto ABS could be affected if the auto loan borrower pays ahead of schedule.
Figure 1 demonstrates that dramatic changes in prepayment speeds have a smaller effect on bond's WAL. A 62% decrease in prepayment speeds will result in an extension of five months to the WAL of the bond, while a 31% increase will result in a contraction of 3.8 months.
Auto ABS offer attractive yields to investors with a short-term investment horizon. Prepayments of auto loans are not as sensitive to interest rate as residential mortgages and home equities because they do not demonstrate any noticeable correlation to interest rate movements. Given that they amortize, they generally are not subject to negative convexity. If we compare older prepayment curves with more recent ones, we see that prepayment speeds have maintained a relatively stable trend. We expect prepayment speeds will remain stable; therefore, which should not pose any risk of acceleration of principal payment to investors.