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Fewer Structural Protections in Today’s Speculative-Grade Subprime Auto Loan ABS (Martin)
As we mentioned in our previous commentary, Single-‘B’ Subprime Auto Loan ABS Gain Popularity as Industry Is Poised for Consolidation (available by clicking here), the current innovation of ‘B’ rated issuances in U.S. subprime auto loan ABS resembles the industry’s first growth phase in the mid-1990s when BB-rated classes first became popular. However, there is an important difference: the earlier genre of below-investment-grade issuances included more structural safeguards for speculative grade investors.
The bulk of the ‘BB’ rated subordinated classes issued in the 90s were part of securitizations in which the senior notes were bond insured. A few of the earliest ‘BB’ rated classes had a turbo feature whereby once credit enhancement (c/e) targets had been achieved and the ‘AAA’ rated bond insured notes had received their monthly distributions, the remaining collections were used to turbo the ‘BB’ rated bonds. As a result, subordination was replaced with overcollateralization (o/c), and no funds were released to the sponsor until the ‘BB’ rated note holders were repaid in full. As ‘BB’ rated notes proliferated and issuers desired releases earlier, this structural feature was eliminated, but other safeguards remained, including triggers.
The bond-insured transactions of the 90s through the Great Recession generally included many triggers, some that were tied to the performance of the underlying collateral and others that were related to the company’s financial position. It wasn’t uncommon for these transactions to include pool-specific delinquency, default, and cumulative net loss (CNL) triggers; and often the CNL definition was defined conservatively such that a certain percentage of late stage delinquencies were included in the CNL calculation. Company-specific triggers included minimum tangible net worth covenants and bankruptcy of the originator. Noncompliance would prevent excess spread from leaving the transaction as it would either be deposited into the reserve account or be used to pay down the notes. Most transactions also included a maximum number of extensions per month.
Given the lack of ‘AAA’ rated bond insurers, bond insurance hasn’t been used as a form of credit enhancement in this market since 2008. Their absence as a control party that structured the transactions and the continued maturation of the subprime auto loan ABS market have led to fewer performance triggers in today’s transactions. Some argue that pool specific triggers don’t benefit transactions in a high-loss scenario because all of the excess spread is being used to cover losses. However, bond-insurance style triggers are generally more effective during periods of mild deterioration, especially if they also include early warning metrics, such as delinquencies and extensions. They prevent funds from being released to the sponsors early in the transactions and increase the overall amount of c/e available to the note holders. This is especially the case for issuers that have more back-loaded loss curves, which has become more common as loan terms have lengthened and delinquencies and extensions have increased. Furthermore, the presence of triggers more closely aligns the interests of the investors with those of the sponsors in that credit performance targets (including passing triggers) much be achieved and maintained in order for the sponsor to receive excess cash flows.
Given the lack of triggers and the growing popularity of ‘B’ rated classes in subprime auto loan ABS, the market is bearing similarities to the speculative corporate bond market where covenant-lite structures are abounding (according to an April 12 S&P Global Ratings publication called Lenders Blinded By Cov-Lite? Highlighting Data On Loan Covenants And Ultimate Recovery Rates, "Through early February 2018, covenant-lite deals accounted for record high 85% of 'B' rated institutional issuance"). The low-interest-rate environment and low default history has resulted in an increasingly borrower-friendly leveraged finance condition as investors seek higher yield.
Issuing deeply subordinated, speculative-grade classes has increased subprime auto loan ABS sponsors' all-in ABS advance rates. At the same time, it has been accompanied with weaker protections for these investors during the next economic or business downturn. The speculative grade classes are highly dependent upon o/c and excess spread and stand to benefit the most from triggers. The investment grade tranches, however, continue to benefit from the typical deleveraging in auto loan ABS due to subordination growing as a percentage of the outstanding collateral. As a result, we expect investment grade ratings for subprime auto loan ABS to remain generally stable to positive. As speculative grade classes continue to gain popularity though, especially single-‘B’ rated classes, we would expect greater rating volatility than in the past.
Turning to the numbers ... The 10yr Treasury was 2.90%, down 3bps w/w. NYMEX crude oil prices increased $4.38 over the week to $69.23/bbl. The S&P 500 was down 27pts w/w at 2,755. U.S. regular gas prices averaged $2.86/gal. on June 22, down 4 cents w/w. The Euro was trading at $1.17, up a penny w/w.
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Research Contacts
James Manzi, CFA (1+434-529-2858; [email protected])
Tom Schopflocher, Ph.D. (1+212-438-6722; [email protected])
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