Prefunding in securitization transaction structures is credit negative because it introduces a risk to ABS investors, according to Moody's Investors Service.
Prefunding was prevalent in the subprime auto ABS market until the 2007 credit crunch. The recent Consumer Portfolio Services (CPS) subprime auto loan securitization includes a prefunding feature. This means that at issuance, the deal holds cash in a prefunding account for the subsequent purchase of auto loans.
"Subprime auto ABS sponsors like prefunding because it is a more cost effective financing for new originations than a warehouse credit facility," Moody's analysts said in a report. "A prefunding feature enables sponsors to take advantage of a favorable interest rate environment by locking in low-rate financing for future receivables. A prefunding feature allows the sponsor to conduct larger bond offerings to take advantage of demand for auto ABS paper, thus saving on fixed costs for the bond offering."
However, prefunded accounts create the risk that the auto loans delivered to the trust in exchange for the cash are of poorer credit quality versus the loans already in the trust.
"In the run-up to 2007, financial guarantors, which used to guaranty auto loan securitizations, kept a close eye on prefunding procedures to ensure that receivables added to the trust after closing were not materially different from the initial loans," Moody's analysts explained.
In the CPS deal, tight eligibility requirements for the auto loans prevent variation in the credit quality and certification from an independent public accountant provide the oversight that the financial guarantors formerly provided, the rating agency explained.
Prefunding also introduces the risk of negative carry. The size of CPS’s prefunding account, which is about 30% of the bond offering, and the fact that it will ramp up loan deliveries over time, means the trust will need to invest a sizable amount in cash, Moody's analysts said.
This cash will not earn interest enough to cover bond costs over the two-month prefunding period. "In CPS’s transaction, the significant levels of excess spread offset the negative carry," said Moody's analysts stated. "In other transactions, the sponsor’s deposit of cash to a trust covers the negative carry."
Moody's also highlighted the reinvestment risk created by prefunding accounts and explained that if CPS does not use all the cash during the prefunding period, the remaining funds in the account will go back to ABS investors at the end of the time period. Investors bear the risk that if interest rates have fallen, they will have to reinvest in lower yielding assets.
"Proposed regulations from the Securities and Exchange Commission reduce prefunding amounts to 10% from 50% of the bond offering in order to prevent sponsors from originating risky loans for subsequent sale to investors," Moody's analysts said.