The auto ABS market survived the financial crisis relatively unscathed.
Even though the sector is showing some minor cracks as the credit cycle proceeds, one indisputable fact will likely drive it forward: Americans need their cars.
It also helps that unlike consumer ABS such as the credit card and student loan asset classes, vehicles can be repossessed and sold.
Recovery rates on those sales have also been at record highs because of a lack of supply. This has been seen over the past few years because of fewer new car sales during the economic downturn and this year due to the tsunami in Japan slowing the country's imports.
Rubin Bahar, senior research analyst on Eagle Asset Management's fixed-income team, said he sees auto loans at the top of a consumer's credit payment waterfall, followed by credit cards, mortgages and student loans.
"If I look at most households, the first check to be written is going to pay off the auto loan, because if I don't do it the vehicle will be repossessed," and vehicles are essential in most Americans' lives, Bahar said.
Like in other highly rated, short-term consumer ABS, including credit cards and equipment leases, spreads on 'AAA'-rated prime auto ABS with a one-year maturity have steadily tightened this year. As of early November, the spread was seven basis points, down from 10 basis points a month earlier and 25 basis points a year ago. The spread is now at the most aggressive level since July 2007, according to a Nov. 15 Wells Fargo Securities Research report.
John McElravey, senior analyst at Wells Fargo, said that money managers running short-duration funds have shifted into consumer ABS in search of a yield premium to Treasury bills, which now pay close to nothing.
As durations increase and credit ratings drop, however, spread levels widen significantly for both prime and subprime auto ABS. McElravey said that is likely to be the case until larger macro issues, such as the European debt crisis, are resolved and investors' fears about liquidity shortages dissipate.
Better Credit Enhancement
Bahar said 'AAA'-rated subprime auto ABS can have spreads as wide as 80 basis points over the swap curve, and the B and C subordinated tranches with spreads as wide as the high 300 basis points over the curve are attractively priced.
That is partly due to the strongly performing collateral and because significant credit enhancement has typically been structured into subprime auto ABS deals. Bahar said he is confident that even B and C subordinated tranches will mature at par, assuming the economy remains in at least its current condition. "I'm not losing sleep over buying those bonds; I'm sure we'll get our money back. I'm just losing sleep on the mark to market - I don't want their price to plummet and then move back to par," he said.
Bahar's confidence stems in part from the significant credit enhancement subprime deals require, demanded by investors after the consumer ABS market all but froze during the financial crisis.
Mark Risi, senior director at Standard & Poor's, noted that 'B'-rated credits typically have one-to-one coverage of credit enhancement, while a 'BB' rating usually has around 1.5 times coverage, and 'AAA' ratings are generally structured with three to five times, depending on whether it's for a prime or subprime credit.
"We recommend that investors go down in credit to pick up additional yield based on the strong credit performance and robust structural protections available in the sector," the Wells Fargo report said.
Tight underwriting standards in the wake of the financial crisis have led to strongly performing collateral in terms of loans originated from 2009 and into 2011. "We think the solid performance of collateral will continue, leading to additional upgrades going forward," Risi said.
Nevertheless, the credit cycle moves forward, and as is typically the case deal terms have softened somewhat on the prime side and more so for subprime transactions.
"Credit quality for prime ABS has moderated, and in the subprime segment the loan-to-value ratio has increased slightly," said Amy Martin, an S&P analyst who focuses on new-issue ABS. Martin added that credit quality in both the prime and subprime subsectors remains strong compared to the few years leading up to the financial crisis.
Deal terms typically loosen when the credit cycle matures, and volume picks up because lenders are reaching out to a broader, less creditworthy swathe of borrowers. As of the week of Nov. 28, the subprime sector had recorded 23 deals totaling $10.8 billion, compared to 10 deals totaling $8.7 billion at this time last year, according to S&P.
"We expect to see an increase in subprime securitization volume next year," Martin said, adding that the rating agency anticipates some of them to be new issuers.
The prime auto segment makes up the largest slice of consumer ABS by far, at 32.5%, according to data from Bloomberg, Informa Global Markets and Wells Fargo. Subprime auto is next, at 13.5%, followed by FFELP student loans and auto leases.
Private Equity Steps In
The subprime auto market, however, appears primed for growth, or at least a number of private-equity firms and other players who have recently invested in the sector appear to think so.
Most recently, Auto Finance Holdings - owned jointly by investment funds affiliated with Warburg Pincus, Kohlberg Kravis Roberts & Co. and Centerbridge Partners - acquired a stake in Santander Consumer USA, which was formed when Banco Santander Centro Hispano purchased Drive Financial five years ago.
Private-equity firms Blackstone Group and Perella Weinberg have each acquired all or parts of subprime lenders, as has U.S. bank holding company Pacific Capital Bancorp and Japanese conglomerate Marubeni.
Martin at S&P noted that the subprime auto sector has been tapping the securitization market for about 20 years and saw a large growth period between 1993 and 1996, when it was first the target of private equity firms and IPOs. Some lenders grew their loan volumes without the proper infrastructures in place to manage this growth. Further, these companies used gain-on-sale accounting (generally no longer used), which resulted in large non-cash gains. When these companies reported higher-than-expected losses, these gains were reversed and investors started to flee the subprime auto finance sector. As a result, the market contracted severely over the next few years. Lenders grew their infrastructures then without the lending growth to support it, however, and the market contracted severely over the next few years.
That growth was exaggerated in part by firms booking anticipated sales by using gain-on-sale accounting. That accounting method is no longer accepted today. And with a seasonally adjusted annualized rate of 13.2 million vehicle sales in October compared to upward of 18 million unit sales before the financial crisis, there appears to be plenty of room for growth.
Nevertheless, investors should monitor private-equity activity in the auto sector, said James Grady, head of structured finance at Deutsche Insurance Asset Management.
Grady said that banks and other strategic buyers are concerned first with stability, credit quality and ensuring a viable business. By contrast, private equity firms are more concerned with increasing sales with the intent of later selling the lender at a profit, Grady said. He added that they will tend to tap the ABS market to extract cash upfront even if that puts a lender's long-term prospects at risk.
"That's a concern to investors," Grady said.