By Adam Tempkin of Reuters IFR
NEW YORK, April 17 (IFR) - Rating agencies have openly conceded that US subprime auto-loan underwriting is loosening and that borrowers’ credit quality will get much worse this year, but they insist that their top investment-grade ratings on the recent surge of subprime auto bonds – many of which they have graded Triple A – are rock solid.
However, not everyone is convinced, including certain skeptical bond investors and rival rating agency analysts, who say that ratings on the white-hot asset class need to be more conservative. They claim that the gilded top rankings given to a spate of recent deals from smaller, second-tier lenders with no long-term asset-backed security (ABS) track record will be in jeopardy if there is another major downturn in the economy.
Still other bond investors have cautiously participated in the sector but are careful to perform their own due diligence on transactions and issuers rather than take the rating agencies' top grades at face value.
Subprime auto bond issuance has skyrocketed over the past year. So far in 2013, nearly US$7.5bn of new subprime auto ABS has been issued, roughly 32% higher than in the same period of 2012, according to Deutsche Bank. There was US$18.5bn in issuance for all of 2012, versus US$11.75bn in 2011.
The low interest-rate environment and tight yields on prime auto ABS have made subprime auto paper an attractive yield play for investors. But the disagreements on the risky asset class have led to some split ratings on senior tranches and a growing debate on the buy-side as to whether the creditworthiness and liquidity of top-rated offerings from second-tier and third-tier companies will hold up over time.
“We are confident that the ratings will hold,” said Mark Risi, a senior director of ABS at S&P, which was the only agency to provide ratings on all four of the subprime auto bond transactions that have been devoured by investors over the past two weeks. Another deal from Detroit-based Credit Acceptance Corp. is expected to be marketed this week, and so far Kroll Bond Ratings and DBRS have granted the deal AAA ratings.
S&P bestowed AAA ratings on two of the recent deals – from issuers AmeriCredit and Prestige Auto – while granting high investment-grade ratings to deals from Mason, Ohio-based Security National Automotive Acceptance Co (SNAAC), which returned to the ABS market last year after a ten-year absence, and Chadds Ford, Pennsylvania-based Flagship Credit Acceptance, which was bought out by investment manager Perella Weinberg Partners in 2010.
Rival agency DBRS actually granted the SNAAC deal a full AAA rating, resulting in a split rating on the senior tranche of AAA/AA (DBRS/S&P). Last week’s Flagship transaction, meanwhile, received a slightly higher rating from Kroll on the senior tranche, leading to another split: A+/AA– (S&P/Kroll).
“We have never downgraded a subprime auto ABS bond for credit reasons since we started covering the sector in 1991,” Risi said. “We’re comfortable with the stress scenarios we impose, as well as our loss expectations, the structural protections on the current deals, and especially the fact that credit enhancement grows as the transaction amortizes.”
So-called credit enhancement is the buffer structured into securitizations that protects senior bondholders in case the underlying loans begin to sour. This "credit support" takes many forms in subprime auto ABS deals.
This includes a reserve account, or funds set aside to reimburse the issuing trust in case of losses; overcollateralization, wherein the face value of the underlying loan portfolio is larger than the security it backs; subordination, where the lower tranches act as protective layers for the more senior tranches; and excess spread, where the interest rates received on the underlying loan collateral is greater than the coupon paid out to bond investors.
Protected
Therefore, the deals are protected by structure, the agencies claim. Some bond deals from 2012 have rating agency-projected expected losses of as much as 25% to 26.5%, yet still received Triple A ratings.
“Structural features will buffer subprime auto ABS despite weakening collateral quality trends,” said Ellen Callahan, an ABS research analyst from Deutsche Bank, who noted that the credit support increases quickly on the deals.
"The ratings quality of these deals as a whole deserves
the benefit of the doubt," said Dave Goodson, head of securitized-product
investing at ING Investment Management. "Consumer ABS had one of the
most stable ratings profiles through the credit crisis.
"That being said, if it was something we participated
in, we would need to do our own due diligence in order to reach a conclusion on
a particular deal," he added.
S&P, DBRS, Kroll, Moody’s and Fitch have all published recent reports warning about a declining trend in subprime auto credit quality, but they have each taken slightly different stances on the matter when it comes to rating new deals.
Fitch and Moody’s have been willing to provide top ratings to the most established, well-known liquid names in the sector, such as GM Financial (formerly AmeriCredit) and Santander Consumer USA. But they have either been deemed too conservative by issuers (and therefore not hired) or have refused to rate several deals from lesser-known or unproven issuers.
Fitch, especially, has avoided a sector it believes is too risky. “We are generally more reluctant to reach AAA on subprime auto ABS for numerous reasons, among them the sector's innately more volatile performance history, operational concerns and often heavy reliance on securitization as sole source of funding” said John Bella, co-head of US ABS ratings at Fitch. “Stiffer competition and deteriorating underwriting in recent months are amplifying our concerns.”
Nearly 25% of the obligors in the recent SNAAC deal – underpinned by loans to military personnel – have no FICO score at all, meaning they do not have credit histories yet, according to DBRS. About 24% have ultra-low FICOs of between 500 and 550, according to S&P. Nearly 24% of the loans have loan-to-value ratios of 115% to 119.99%, meaning that these obligors borrowed more than their car is worth.
S&P said that it would not assign a rating to the deal higher than AA because "the company reentered the securitization market in 2012 after 10 years and has yet to establish a securitization track record; its SNAAC 2012-1 transaction has less than 12 months of securitization performance data."
Meanwhile, Utah-based Prestige Auto priced a US$350m subprime auto bond on April 3, with Triple A ratings from S&P and DBRS on the senior tranches. The company caters to borrowers who have recently declared bankruptcy. Specifically, Prestige lends to car buyers who have filed for bankruptcy and opt to purchase a vehicle prior to the closing or "discharge" of their bankruptcy.
The rating agencies said that the presence of so-called bankruptcy collateral actually helps the performance of the underlying pool, because many of the debts an obligor had were discharged as a result of the bankruptcy filing, or are being repaid in accordance with a court order. Court documentation allows Prestige to calculate a more precise debt-to-income ratio, according to DBRS.
The deal also featured a so-called prefunding account, a riskier structure not seen in ABS since before the financial crisis. The funds in the account will be used to purchase up to US$58m in additional collateral after the close of the transaction. The risk is that new auto loans delivered to the trust could be poorer in credit quality than those already in the pool.
Buyer beware
John Kerschner, the head of securitized-product investing at Janus Capital Group, says that he prefers to stick to subprime auto deals from only the largest and best-known programmatic issuers.
“The gap between the biggest players and the smaller issuers is just massive,” Kerschner said. “The smaller second-tier players go to deep, deep subprime, in the range of a 500 FICO score. That may not be the person you want to lend money to.”
Kerschner says he has a better feel for predicting how the larger, liquid players’ deals will perform throughout all cycles of the market.
Officials at Prestige Auto beg to differ. "We have since 1996 issued more than US$2bn in subprime ABS, with no events of default or accelerations, notwithstanding the ensuing economic cycles," Aaron Dalton, senior vice president of structured finance and business development at Prestige Financial Services, told IFR.
He added that data show that Prestige's ABS deals have performed similarly to transactions from GM Financial and Santander.
Other bond investors have participated in recent deals, but are sure to personally meet with management and understand the business model of a smaller subprime lender before investing in a transaction. "I do site visits and try to find out who really owns the company," said Mike Kagawa, a senior ABS portfolio manager at Payden & Rygel in Los Angeles.
"Do I trust ratings? No. But I take each deal on a case-by-case basis," Kagawa said. "I'm particularly wary of private equity involvement in the subprime auto sector. It's not a problem at the moment, but when the cycle turns, it could be a red flag."
"We like to have the opportunity to speak with management first," added a Boston-based ABS portfolio manager who invests in subordinate slices of subprime auto ABS deals. "We do our own assessments of the loan pool; we don't base it on the credit ratings."
In recent years, private equity companies such as KKR & Co, Warburg Pincus, Centerbridge Partners and Blackstone have bought stakes in various smaller subprime-auto companies.
Janus' Kerschner says that with investors hunting for yield wherever they can get it, and underwriting slipping, investors should be wary of smaller issuers who have no recent history in the ABS market.
“Credit rating agencies have their models and they usually work, but sometimes they’re just drastically off," Kerschner said. "For subprime auto, it’s the kind of model that works … until it doesn’t.
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