New Commingling Reserve Mechanism in German Auto ABS Requires Further Considerations in Our Cash Flow Analysis (Tuchenhagen/Venkatachalam)

Commingling in German Auto ABS Transactions

As mentioned in our recent webcast (see replay here), S&P Global Ratings observed structural changes to commingling reserves in German Auto ABS transactions since 2017, whereby the required commingling reserve funding amount is reduced based on a build-up of relative credit enhancement, which is used to partially, or even fully, cover potential commingling loss. In Germany, we typically assume the amount at risk of being commingled with the servicer’s insolvency estate to be a loss. These amounts generally comprise: a) the amounts sitting on the servicer accounts before being swept to the SPV’s accounts, and b) any amounts paid to the then insolvent servicer by the borrowers—before they have been notified—to crystalize the asset transfer. Further, these amounts vary depending on the transactions’ collateral payment profile, specifically rising in portfolios with large balloon payments when such payments become due three to four years post contract origination. In German Auto ABS transactions rated by S&P Global Ratings, we have seen this risk mitigated through different mechanisms, most commonly through dynamic or static commingling reserves, sized to cover the entire risk, based on expected collections (including principal, interest, and prepayments) over the commingling risk time horizon.

Recent Structural Changes in Sizing Commingling Reserves

We observed the new funding mechanism with little deviations in three German Auto ABS transactions: Silver Arrow 8, Red & Black Auto Germany 5 UG, and SC Germany Auto 2018-1, none of which S&P Global Ratings has rated. In all these transactions, based on our review of publicly available transaction documents, the servicer funds a dynamic commingling reserve, once downgraded below certain rating thresholds.

The size of the commingling reserve is driven by the level of credit enhancement (including cash reserve) already available to the most senior tranche. Typically, in these deals, the sequential pay structure and non-amortizing cash reserve help build credit enhancement as the transaction deleverages. To the extent that such available credit enhancement exceeds a certain threshold—generally the available credit enhancement at closing on the most senior tranche—the excess is used to mitigate any commingled losses, instead of posting a separate commingling reserve for the entire risk. For example, if the credit enhancement at closing for the most senior tranche in a transaction is 10%, any build-up of credit enhancement over and above this threshold due to deleveraging is potentially available to cover any commingling loss. Consequently, the transaction could likely reach a stage where no commingling reserve is funded, but potential commingling loss is entirely mitigated through the build-up of hard credit enhancement. We can see this in Chart 1 below, where, month from 34 onward, the actual commingling reserve funded (blue line) reaches zero, as additional build-up of credit enhancement (grey line) covers the entire expected commingling loss (orange line).

Chart 1

New Commingling Reserve Mechanism Could Pose New Risks

We believe that, ceterus paribus, this mechanism introduces a pro rata like feature in an otherwise sequentially paying transaction. This is because, despite the minimum threshold criteria on credit enhancement (10% in our example above), any additional build-up (which could potentially mitigate credit losses) would no longer be available once it is applied to mitigate commingling loss. This risk magnifies in delayed recessionary scenarios, specifically in transactions with a high level of balloon payments, which have a lumpy collateral payment profile. For example, in a transaction with a WAL of about 2.5 years and 50% balloon payments, which are concentrated between months 28–35 and 42–45, maximum erosion of the additional credit enhancement could potentially occur towards the end of the balloon peaks, if commingling losses were to occur in those periods. This can be seen in Chart 2, where the available credit enhancement (orange line), which are point-in-time values, deplete significantly from potentially available credit enhancement (blue line) in that month, assuming credit enhancement is applied to mitigate commingling losses in the specific month.

Chart 2

How S&P Global would address this risk in the cash flow analysis

In our view, this feature could introduce potential rating volatility, especially at the tail-end of the transaction’s life, although this would depend on the transaction's collateral features. Based on our cash flow analysis of the above transactions, we have observed that the transactions’ collateral payment profile, recession timing, and timing of commingling losses impact available credit enhancement to cover credit losses. Hence, in our analysis, we would consider these factors along with the amortizing commingling reserve to run different cash flow scenarios to assess the potential impact.

We expect to provide a more detailed commentary in due course, focusing on the cash flow impact considering this mechanism in typical German Auto ABS transactions.