Single-‘B’ Subprime Auto Loan ABS Gain Popularity as Industry Is Poised for Consolidation (Martin)

We’ve Been Down this Road Before
About every 10 years since the mid-1990s, the subprime auto loan sector and related ABS market have experienced a growth phase followed by a contractionary period. We saw this in 1995–1996 when dozens of small startup subprime auto finance companies raised equity in the IPO market, and several of these entities securitized in the ABS market, mostly using bond insurance as the primary form of credit enhancement. Beginning in 1997, due to higher-than-expected loan losses and problematic accounting issues, many of these companies started to fail. From 1997–1999 many in the industry filed for bankruptcy, and others avoided bankruptcy by selling themselves or their loan portfolios. Ten years later, the auto finance industry, as well as other specialty finance sectors , experienced a credit-induced contraction during which many companies stopped making loans, and some sold their portfolios or their entire operations to larger players. Now, a decade later, it appears as though we are poised to begin another period of consolidation.

The current round of consolidation appears to have started in March with the sale of Pelican Auto Finance to Westlake Financial Services. Pelican entered the subprime arena in 2013 just as the market was becoming intensely competitive, credit standards were loosening, and profit margins were narrowing. In the same month, Summit Financial Corp. and Ace Motor Acceptance Corp. filed for bankruptcy protection. Fortunately for ABS investors, none of these entities had any auto loan ABS outstanding. Some lenders, including former securitizers, have stopped (or nearly stopped) originating loans, and others have curtailed their lending volumes substantially. The pull-back in lending activity, which we also saw in 2016 and 2017, is likely in response to credit losses exceeding expectations—which typically occurs in the late stages of a credit cycle—as well as capital and liquidity constraints.

Strong Investor Interest
The current cycle bears another similarity to prior cycles: significant investor appetite for this asset class, as demonstrated by the plethora of single ‘B’ rated classes being sold this year (see table below).

'B' Rated Subprime Auto Loan ABS Issuance in 2018

In total, approximately $141mn in ‘B’ rated subprime auto loan ABS notes at time of issuance has been sold YTD, compared to zero in 2017. This is reminiscent of the mid-1990s when ‘BB’ rated classes first become popular. Auto-related ABS volume carrying ‘BB’ ratings grew from $5.2mn in 1995 to $26.2mn in 1996, and approximately $60mn in 1997, just as the subprime auto loan industry was beginning to unravel.
The reasons for the growth in single ‘B’ rated securities today mirror those that gave rise to the popularity of ‘BB’ rated securities in the mid 1990’s:

• the maturation of the subprime auto loan ABS market;
• wider acceptance of speculative ratings in the ABS market, fueled by investor demand for higher yield; and
• the growth in the number of independent subprime auto finance companies using the securitization market as their primary funding source, desiring to maximize proceeds from bond issuance.

Subprime Auto Loan Securitizers Still Retain Risk in These Deals
With the advent of ‘B’ ratings in subprime auto loan ABS, some have questioned whether the sponsors of these transactions are still retaining any of the risk. Indeed, they are, as they must comply with risk retention rules that require them to hold a 5% stake.

S&P Global Ratings' Approach to Rating Non-investment Grade Subprime Auto Loan ABS
Our rating approach for non-investment grade classes is similar to that for investment grade classes, but the amount of credit enhancement available to cover losses (all things equal) is significantly lower. Additionally, the structures are not designed to cover moderate risk scenarios (equivalent to a 'BBB' stress) wherein losses equal at least 1.35x–1.5x base case expected levels. (The multiple within the range depends upon the base case loss level, with lower multiples being applied to higher loss proxies.) For subprime auto loan ABS transactions, the multiple of base case losses that non-investment grade classes are designed to cover is only 1.2–1.35x at the 'BB' rating level and only 1–1.1x at the 'B' rating level. Therefore, even slight deviations from expectations can lead to losses on the bonds.

More Rating Volatility Is Expected On Non-investment Grade Tranches
The subprime auto loan ABS market has experienced positive rating movements with approximately 1,100 upgrades YTD from 2004, and no downgrades. However, we believe it is important to remind investors that speculative grade classes are subject to greater rating volatility than investment grade ratings, and there is no rating history on how single 'B' rated subprime auto loan classes have performed through prior economic or business downturns. Certainly as the number of 'BB' and 'B' rated classes grows, we would expect rating performance to become more volatile than it has been in the past.

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