There has been a significant increase in subprime auto lending during the past year as new lenders joined established ones in extending loans to subprime borrowers looking to purchase vehicles. As competition heats up, and after a period of tight underwriting from 2009 through 2011, Standard & Poor’s Ratings Services saw borrower demographics and underwriting standards begin to return to more typical levels in 2012, a trend we expect to continue throughout 2013.
We expected this shift in underwriting after the economy emerged from the recession, when it was difficult for subprime buyers to finance an auto purchase. This recent return to a more typical subprime borrower base is therefore marked by lower credit scores (FICOs) and higher loan-to-value (LTV) ratios than during the tight underwriting of 2009 through 2011.
We expect that this less-conservative underwriting will have a negative impact on subprime auto loan asset-backed securities (ABS) performance, and indeed we are already seeing some signs of slight collateral deterioration. However, certain risk mitigants have lessened the ratings impact.
These include strong payment structures and high credit enhancement levels, which offer additional loss protection. As a result, we do not believe that the expected deterioration in collateral performance in 2013 will result in negative rating actions for subprime auto ABS.
Since we began rating subprime auto loan ABS transactions in 1991, we have not lowered a public rating due to credit deterioration— even during the most recent recession between 2006 and 2008, when losses nearly doubled. We attribute much of this rating stability to strong transaction features, such as sequential payment structures (where the senior notes are paid first), credit-enhancement floors, and performance-related early amortization triggers. These structural features in auto loan ABS transactions typically result in increased credit enhancement levels as the collateral amortizes. For example, in 12 transactions rated in the first half of 2012, hard credit enhancement (credit enhancement from sources other than excess spread) increased by more than 33%, on average, in just the first six months.
Key Issuer- and Deal-Level Analytical Considerations
When we analyze a subprime auto loan transaction, in addition to the collateral features, we review the following originator/servicer characteristics (particularly in the case of issuers that are new to the ABS markets): the financial performance and funding capacity of the originator/servicer, the originator/servicer’s management team, and the underwriting and servicing strategy/capabilities of the originator/servicer. We believe that a financially viable and experienced servicer is key to a subprime portfolio maintaining stable and predictable performance. Generally, a backup servicer can also play an important role in partially mitigating the risk that an originator/servicer will go bankrupt, and as such, many subprime auto loan ABS transactions include backup servicing arrangements.
Furthermore, we also consider the level of management’s financial commitment to the company, as we believe an originator/servicer with a stronger commitment has additional incentive to focus heavily on underwriting and collections.
A review of these variables helps inform our decision as to the highest rating we would assign to a subprime auto loan ABS transaction. For many transactions in this sector, including most transactions we rated in the past few years from first-time issuers, we have rated the senior notes below ‘AAA’.
In addition, we analyze the transaction structure to determine the level of credit protection available to cover potential losses on the collateral. Most, but not all, of the transactions we have seen are sequential-pay structures with subordinate classes of notes, overcollateralization, and a reserve account.
In addition, the reserve account and overcollateralization amounts are typically structured so that the amount does not decrease as the collateral amortizes, thereby providing an enhancement floor to protect against liquidity shortfalls and collateral losses at the tail-end of the transaction. Furthermore, given the subprime nature of the borrower, the yield on the collateral is typically relatively high, leading to higher levels of excess spread (though our analysis assumes lower levels of excess spread to cover losses, as variables such as prepayments and loss timing can influence the level of excess spread available).
Given the short tenor of the notes and the use of credit-enhancement floors, these transactions typically deleverage rapidly. That is, the amount of credit support typically grows as a percent of the amortizing collateral balance. Through cash-flow simulations, we assess whether the enhancement levels are commensurate with the related stressed ratings scenario and whether our ratings will meet our stability criteria in a moderate stress scenario. We have outlined our approach to rating a subprime auto loan ABS in “Standard & Poor’s Explains Its Approach To Rating Subprime Auto Loan ABS Transactions,” published Aug. 29, 2011.
Increased Competition and Its Impact on Collateral Trends
Some 35 subprime auto loan ABS transactions were issued in 2012, totaling roughly $18.5 billion. This is up from $11.8 billion in 2011 and was the highest volume since 2006. Although a number of seasoned subprime issuers —such as AmeriCredit (now GM Financial), Santander Consumer USA, and Consumer Portfolio Services —continue to tap the ABS markets, we have rated transactions from seven subprime issuers that have entered or returned to the ABS market since 2010, though the management teams of many of these new entrants have prior experience in subprime auto lending. The new entrants in the subprime auto segment have increased competition, which has boosted pricing and underwriting pressure.
The borrower FICO scores and vehicle LTVs for the subprime ABS transactions that we rated in 2012 demonstrate the resulting weaker collateral performance. The weighted-average FICO score for this vintage was 571, down from 578 in 2011 and 573 in 2010. However, we do not believe that FICO scores are the sole predictors of subprime performance, as the structure of the auto loan itself also has a significant bearing on the borrower’s propensity to repay it. For example, although LTV ratios have risen in 2012 (averaging 115.7, up from 112.7 in the prior year), they remain lower than they were in 2007 and 2008, when they averaged about 120.3.
In terms of collateral losses, the recent shift to more normalized underwriting has begun to manifest itself in slightly higher losses in the subprime auto loan ABS sector. Over the past few years, the subprime sector’s collateral performance was the strongest on record, but recently there have been some signs of weakening. The average annualized net loss for the second half of 2012 increased to 5.72%, which was up from 5.51% and 5.31% for the second halves of 2011 and 2010, respectively. However, the second-half losses remain well below the highs of 9.10% and 9.97% in the second halves of 2009 and 2008, respectively.
Despite the increased competition and weakening collateral characteristics, the impact on collateral performance so far has been slight. We expect subprime auto ABS collateral losses to continue to move upward in 2013, reflecting the shift in underwriting. However, we expect losses to remain well below the 2008 and 2009 levels.
Despite credit standards returning to a more typical subprime demographic and the resulting higher losses, we expect ratings stability in this sector to continue. Our ratings outlook for 2013 remains stable to positive. We have upgraded more than 150 subprime auto loan ABS transactions since 2004, and we expect that trend to continue. Conversely, we have never downgraded a publicly rated subprime auto loan ABS due to credit deterioration, even during the 2006-2008 recession.
Subprime Auto Loan ABS Structures Allow for Significant Enhancement Growth
To evaluate the relative strength of subprime auto loan ABS structures, we examined 12 transactions that we rated in the first half of 2012 to determine how much the Class A credit enhancement grew over the first six months. Each of the 12 transactions had initial expected cumulative net losses of more than 10%. The transactions are from eight issuers, four of which are first-time ABS issuers. The other four are veteran ABS issuers. Also, each of the transactions has credit support in the form of overcollateralization, subordination, reserve account, and excess spread. Ten of the structures are sequential pay, and the other two are pro rata pay. For the purposes of this exercise, we only examined the hard credit enhancement and excluded the excess spread.
As shown in the table above, our sample of subprime auto loan ABS transactions had initial hard credit support of 36.17%, on average, for the Class As. After six months of performance and with an average collateral reduction of 16.89% (a pool factor of 83.11%), the average hard credit support grew to 47.90%. This is a 33.66% average growth in credit enhancement after just six months. Each transaction in our sample reached the reserve account target by the sixth month, and four of the 12 reached their over-collateralization target by the same point. The over-collateralization grew, on average, by more than 76%; the reserve account grew by about 40%; and the subordination grew by over 20%.
With the average hard credit support growing to almost 50% on average, and assuming a future recovery rate of 40%, these subprime auto loan ABS transactions would be able to withstand almost 80% of the collateral defaulting before the senior classes would default on their principal payments.
In our view, this is significant loss coverage and, as noted, does not take into account the significant excess spread, which acts as the first level of loss coverage for these transactions. Given the relatively high yield on the assets and the relatively low cost of funds in today’s market, excess spread is a more significant portion of the enhancement than it has been in the past.
As the heightened competitive environment in the subprime auto loan sector continues, we expect collateral performance to weaken further following a period of excessive tightening.
As a result, we expect losses in 2013 to be higher than in the past two years.
However, we continue to believe that the structural strengths built into these securitizations will help offset the higher losses. As such, we expect the stable-to-positive ratings trend for subprime auto loan ABS to continue in 2013.
Mark Risi, senior director, U.S. ABS surveillance at Standard & Poor’s Ratings Services