The fundamentals of equipment ABS are stronger than ever as lessons learned from the prior two recessions have resulted in quality and performance improvements which will help the asset class weather future economic downturns.
These lessons relate to the importance of the operational capability and stability of originators/servicers, essential-use nature of equipment, sensitivity of different equipment types to macroeconomic and sector-specific factors, and deleveraging enhancement structures.
Equipment ABS is currently displaying solid performance, with delinquencies and losses tracking well below historical averages. Fitch expects equipment ABS transaction rating performance to be mostly stable for 2014, with a possibility of some rating upgrades. That said, Fitch does expect delinquency and loss levels to rise modestly as portfolio performance normalizes following what is commonly referred to as the “great recession.”
While the 2000/2001 recession was not as severe as the great recession by most standards, this was not the case with regard to small-ticket equipment ABS performance. As seen in the graph below, small-ticket total delinquencies reached a 2000/2001 recessionary peak of 7.39% in December 2000 versus 5.42% in March 2009. Similarly, the ANL index hit 4.09% in January 2002, above the great recession peak of 2.17% experienced in November 2009.
The reason for the discrepancy primarily lies in the different issuer compositions seen during the two recessions. The small-ticket equipment ABS market of the late 90s was dominated by independent, thinly capitalized originators/servicers. Fierce competition and the appetite for growth resulted in aggressive underwriting at the expense of portfolio quality. At the onset of the 2000/2001 recession, which was ushered in by the end of the dot com boom, delinquencies and losses on small-ticket ABS portfolios began to rise.
Originators/servicers themselves felt the impact of the downturn as a number of them filed for bankruptcy. This further hurt performance on the outstanding ABS transactions as servicer bankruptcies and transitions often resulted in increases in delinquencies and defaults, as well as decreases and delays in recoveries.
Flash forward to the great recession, when small-ticket equipment ABS fared much better. For one, the issuer landscape changed dramatically due to the aforementioned bankruptcies as well as industry consolidation. It now consists of a smaller number of established, better-capitalized finance companies. Underwriting standards had improved through lessons learned from the prior recession. In addition, more advanced tools and processes were available to originators, which allowed them to focus more attention on marginal credits. As a result, both the issuers/servicers as well as the obligors in the portfolios were in a better position to weather the great recession.
Furthermore, the ABS transaction structures had improved, featuring a greater amount of classes with deleveraging enhancement profiles. While delinquencies and losses did experience upticks in the great recession, the higher quality of servicing and increasing credit enhancement levels led to no negative rating actions taken by Fitch on any of its rated small-ticket ABS transaction due to collateral performance.
Unlike small-ticket equipment ABS, the composition of heavy metal ABS issuers has remained fairly consistent, with only a few issuers accounting for most of the new issuance through the last two recessions. As seen in the chart below, delinquencies and losses increased in the 2000/2001 recession for the sector. However, the increase was not as severe as what was experienced in 2009. Sixty-plus day delinquencies reached a recessionary peak of just 1.87% in March 2000 but hit 2.40% in November 2009. ANL topped out at 1.34% in November 2001 versus 1.90% in October 2009.
In addition to a more severe recession, the primary driver of worse delinquency and loss performance for heavy metal equipment ABS in 2009 was the decline in construction spending. This was especially true for the residential sector. This significantly stressed the large portions of the outstanding transactions backed by loans on construction equipment.
While delinquencies increased substantially in 2009, the fundamentals of heavy metal equipment ABS kept losses in check. While delinquency levels rose from a pre-recessionary low of 0.30% in July 2005 to 8.36% in November 2009 (a 2,600% increase), ANL only rose from 0.21% in November 2006 to 1.90% in Oct. 2009 (an 800% increase). Deterioration in loss performance was minimized in part by the characteristics of the equipment.
Due to the income-producing nature of agricultural and construction equipment, obligors are less likely to default on their payments as they rely on the equipment to operate their business. Furthermore, heavy metal equipment has historically realized a higher recovery rate than small-ticket equipment. While recovery rates softened during the recession, they nevertheless helped minimize the impact of losses on outstanding transactions.
It is also important to note that heavy metal equipment ABS losses were kept in check through attentive servicing. Unlike the issuer landscape for small-ticket equipment ABS in 2000, the majority of heavy metal equipment ABS has been from a smaller number of financially sound, well-established companies. As such, they were able to weather the recession and better service their outstanding portfolios and work out delinquent accounts to avoid potential obligor defaults.
Consistent with the small-ticket equipment ABS issued in the same timeframe, heavy metal transactions outstanding in the great recession featured deleveraging structures which helped protect the notes from increases in net losses. As a result, Fitch did not take any negative rating actions on any heavy metal equipment ABS as a result of collateral performance. In response to the worse performance experienced during the great recession, issuers have overall decreased the concentration of construction equipment in heavy metal equipment ABS. While increasing the concentration of agricultural equipment relative to overall pool diversity, Fitch views the change positively in light of past performance.
Peter Manofsky is a Director in Fitch’s U.S. ABS group; John Bella heads Fitch’s U.S. auto and commercial ABS group.