- Although employment disruptions caused by the COVID-19 pandemic will put stress on consumers' ability to pay their auto obligations, auto loan ABS have numerous structural protections that we believe will protect transactions from near-term liquidity-related bond defaults. Higher credit losses could impair ratings over the longer term, however.
- In our view, the transactions that are at greatest risk of downgrade and default are subprime auto loan ABS with noninvestment-grade classes.
- In light of the weakened economic outlook, we are increasing our base-case level of cumulative net losses and modifying certain cash flow assumptions, and will run additional sensitivity scenarios as we deem appropriate.
The COVID-19-induced economic dislocation will have a negative impact on the wages of many, and unemployment will inevitably rise significantly from its current historically low level, especially in those states where nonessential businesses have been ordered to close and residents have been advised to stay home. This will, in turn, affect the ability of many to pay their living expenses, including their auto loans. Approximately 14% of outstanding auto loans are financed in the auto loan asset-backed securities (ABS) market. The subprime auto segment is more dependent on the ABS market: About 25% of the subprime auto loans originated last year were securitized in rated ABS. As subprime borrowers will suffer the greatest financial hardships from the COVID-19 impact, this segment of the ABS auto loan market, in S&P Global Ratings' view, is at the greatest risk of ratings disruption.
S&P Global Ratings acknowledges a high degree of uncertainty about the rate of spread and peak of the coronavirus outbreak. Some government authorities estimate the pandemic will peak around midyear, and we are using this assumption in assessing the economic and credit implications. In our view, the measures adopted to contain COVID-19 have pushed the global economy into recession (see our macroeconomic and credit updates at www.spglobal.com/ratings). As the situation evolves, we will update our assumptions and estimates accordingly.
Weakening Auto Loan ABS Credit Performance Is Likely
In the near term, we expect auto loan delinquencies and extensions to increase. Lenders and their associated servicing arms have indicated that they are already providing extensions to those affected by COVID-19. This would be similar to steps that were taken after hurricanes Harvey and Irma in 2017 when extensions provided short-term relief for those with temporary hardships. However, we expect a greater spike in late payments than in September 2017 because COVID-19 has caused work stoppages across a much wider swath of the U.S., and the higher level of late payments will likely last for considerably longer.
Due to the strong correlation between unemployment and auto loan losses and our expectation that unemployment levels will rise due to COVID-19, we anticipate that credit performance in auto loan ABS will weaken. As such, we have modified some of our rating assumptions and scenario testing to appropriately address the liquidity and credit concerns that may manifest in new auto loan ABS transactions coming to market. We expect auto loan ABS issuance to resume shortly due to the March 23, 2020, announcement that the U.S. Department of the Treasury and the Federal Reserve will implement the Term Asset-Backed Securities Loan Facility (TALF) 2.0 program to support new issuance of ABS.
We believe cash collections on auto loan ABS transactions will temporarily decline from normal levels over the next few months. The reduction will stem not only from deferrals and delinquencies, but also servicing disruptions (including delayed repossessions and recoveries) and reduced collection effectiveness as finance companies implement new social distancing protocols that include working remotely. Reduced cash flows could weaken liquidity or, more specifically, the ability to pay timely interest and principal by final maturity.
We believe most auto loan ABS transactions can absorb temporary reductions in cash inflows and still meet timely interest because:
- Both principal and interest collected on the loans are available to pay bond interest;
- Excess spread (the difference between the pool's weighted average annual percentage rate and the cost of the debt plus servicing fees) is material in these transactions and helps to offset the delay in payments caused by delinquencies and extensions;
- Auto loan ABS transactions have reserve accounts that can be used to make required debt payments. Prime and subprime auto loan ABS generally have reserve accounts equal to 0.25%-0.50% and 1.0%-2.0%, respectively. Given the low prevailing bond coupons that existed through early March, these reserve accounts provide nearly two to four months and four to six months of interest coverage for prime and subprime auto loan ABS, respectively; and
- Certain prime transactions include yield supplement reserve accounts and yield supplement overcollateralization amounts that are intended to be used to pay bond interest.
Principal by final maturity--money market classes
The outstanding transactions that have money market Rule 2a-7-eligible classes could be vulnerable to nonpayment if collections were to diminish significantly. However, based on our review of S&P Global Ratings 'A-1+' rated auto loan transactions with these securities outstanding for more than a month, collection rates would have to drop by more than 50% before these classes would default at final maturity.
Money market classes have a significant cushion due to conservative modeling assumptions. When rating these classes, we ignore the high level of excess spread (interest income remaining after paying bond interest and fees) that is used to pay the class and build overcollateralization to its target. This is a typical structural feature that accelerates the paydown of the money market class during its first few months and explains why these classes are usually paid off several months early. Further, we assume: only 12 months of principal collections are available to pay these 13-month securities (or 11 months if the class has a 12-month legal final), very low prepayments (generally 0.25% ABS to 0.5% ABS), no defaults or recoveries, and no draw on the reserve account. During typical times, we would consider the above sizing assumptions to be appropriately conservative; however, given our current outlook, we think it's appropriate to assume zero prepayments and potentially other haircuts.
Principal by final maturity--longer-dated, non-money market classes
To test the legal final maturity for non-money market classes, we assume zero prepayments and zero losses, and give no credit to the reserve account to meet the legal final maturity dates. Running defaults, due to the liquid nature of credit support and the quick realization of recovery proceeds (generally within three to four months), would accelerate the paydown of the assets and the bonds. After applying the "zero/zero" assumption to the cash flow runs to see when the notes would be repaid, three to four months of cushion is generally added to such date. Further, for the longest-dated security, the legal final maturity is normally set as equal to the tenor of the longest receivable in the pool, plus the prefunding or revolving period, if any, plus usually approximately six to nine months to accommodate extensions on the receivables. Given that we're likely to see more extensions in the near term, we may run additional liquidity scenarios or require more months of cushion in the legal final maturity dates to the extent the lenders have liberalized their extension policies beyond what was formerly set out in their transaction documents.
|Liquidity Risks Associated With COVID-19 For Auto Loan ABS And Structural Mitigants|
|Payment of timely interest||Payment of principal by final maturity|
|COVID-19 potential impact||High delinquencies and extensions resulting in a delay in the receipt of funds.||High delinquencies and extensions resulting in a delay in the receipt of funds.|
|Structural mitigating factors||All collections are available to pay bond interest expense.||Our standard money market sizing assumptions include: low prepayments, no losses, only loan principal is used (no excess spread), 100% of one month's principal is unavailable, and no reserve account draw. For longer-dated maturities, the legal final maturity is set based on zero losses and zero prepayments plus three to four extra months. The maturity on the longest-dated class equals the longest maturing receivable plus prefunding and revolving periods, if any, and several months to reflect the company's extension policy.|
|The ability to use the reserve account, which generally covers two to four months and four to six months of interest coverage for prime and subprime auto loan ABS, respectively. Some prime deals also have yield supplement accounts that are intended to be used to pay timely interest.||The ability to use the reserve account.|
|Servicers are generally required to buy back contracts that they've extended or modified beyond their normal servicing policies or the terms outlined in their securitization documents.||Servicers are generally required to buy back contracts that they've extended or modified beyond their normal servicing policies or the terms outlined in their securitization documents.|
|Cash flow assumption changes and additional sensitivity scenarios||May run additional liquidity sensitivity runs to test the structure for potentially higher extensions early in the life of a transaction.||For money market sizing, assume no prepayments and potentially other haircuts. For longer-dated classes, we may assume more months of cushion to account for extensions if the servicer has liberalized its extension policy.|
Auto loan credit performance has historically been highly correlated with unemployment levels, as we illustrated in "Investigating U.S. Auto Loan Credit Performance During Economic Downturns, 1925-2010," published Jan. 5, 2011. Our regression analysis found that the unemployment rate explained about 55% and 66% of the loss performance in prime and subprime auto loan losses, respectively. The regression coefficient from our analysis on prime auto loans suggested that a 100% increase in the unemployment rate resulted in a 119% increase in prime loan losses during economic downturns with rising unemployment rates (the time period covered was 2000 to early 2010). The correlation was much stronger for subprime auto loans at first when the changes in unemployment were small, but the coefficient declined significantly when the unemployment rate increased more dramatically. We believe this was due to subprime auto lenders quickly tightening their underwriting standards and curtailing lending volumes to stem the rise in losses and preserve liquidity. Indeed, some subprime lenders have already started to advance less for the loans they acquire from dealers and are reducing their lending volumes.
In our view, auto loan ABS collateral losses are likely to rise in tandem with higher unemployment levels, but on a slightly lagged basis. Higher losses will follow a period of elevated extensions and delinquencies. When delinquent accounts age past their normal charge-off period or some obligors willingly surrender their vehicles, there will likely be higher full balance charge-offs. Recoveries could be delayed by the inability to repossess and liquidate vehicles due to COVID-19-related shut downs of certain government offices, towing businesses, and auction houses.
We believe the auto loan securities most at risk of downgrade are speculative-grade (those rated 'BB+ (sf)' or lower) subprime auto loan ABS. By definition, these classes have lower credit enhancement with which to cover higher-than-expected losses. Further, a large portion of credit support for these deeply subordinated classes comes from excess spread, which is volatile and can be impaired by a number of factors, including the timing of losses. Subprime pools vary widely in terms of cumulative expected loss levels, ranging from 10% to 28%.
In addition, we believe the imminent recession will negatively affect obligors in the subprime pools to a greater extent than consumers within the prime segment. While consumers in the prime pools will likely be hurt by job losses, many may have financial resources to draw upon to cover a one- or two-month loss of income. Many obligors in the subprime pools, though, may not have savings to cover a temporary loss of income. Further, we believe the tremendous spike in unemployment claims among hourly workers will have a greater impact on the subprime pools than the prime ones.
Currently, approximately 16.0% of the subprime auto loan ABS rated by S&P Global Ratings consist of classes rated in the 'BB' and 'B' categories. On a dollar basis, this equates to approximately $2.8 billion, or only 2.5% of outstanding auto loan ABS rated by S&P Global Ratings.
Certain prime auto loan ABS could also be vulnerable to downgrade, but, based on the rating performance from the Great Recession, we believe these would be largely confined to 'BBB' rated classes where the base case is particularly low (such as 0.8% to 1.0%). However, few prime shelves issue down to the 'BBB' category. Additionally, those pools that straddle the fence between prime and subprime, which we often refer to as "nonprime," have demonstrated a volatile track record of losses and could, at the low-investment-grade and lower levels, be vulnerable to downgrades. At present, there are 20 prime classes rated 'BBB (sf)' totaling $415 million, which is less than 1% of the dollar amount of prime auto loan ABS outstanding.
Changes to base case to reflect the current environment
Given our current recessionary outlook, we are increasing our base case losses for securitizations. Our rating approach incorporates a forward view of the economy. Given our current belief is that the economic downturn will be shorter than the Great Recession (although that view could change), we believe our elevated base case loss levels should translate into higher credit enhancement levels at the 'BBB' and lower rating categories. At present, we do not believe that the current environment alone necessitates an increase in our 'A' to 'AAA' rating levels, although that could change.
|How Credit Risk Is Addressed In Auto Loan ABS|
|High level of credit stress for 'AAA', 'AA', and 'A' rated auto loan ABS||When rating prime auto loan ABS, the credit enhancement (inclusive of excess spread) can cover at least 4x-5x, 3.2x-4x, and 2.4x-3x base case losses, respectively, while simultaneously incurring a stress to excess spread by assuming high prepayment rates. Subprime auto loan 'AAA' rated ABS can generally cover 2.4x-3.5x (depending upon the loss level) base case net losses, which, after accounting for recoveries, generally results in break-even gross losses of 60% to 95%. 'AA' rated subprime transactions generally cover 2.1x-3.0x base case net losses and break-even cumulative gross defaults of 50% to 90%. 'A' rated subprime transactions generally cover 1.7x -2.3x base case net losses and break-even cumulative gross defaults of 40%-75%.|
|Sequential pay||Auto loan ABS generally pay the bonds in a sequential order, causing the subordinated classes to grow as a percentage of the outstanding collateral amount, which builds credit enhancement for the senior classes.|
|Floors to O/C||Floors to the O/C amount allow credit enhancement to grow as a percentage of the declining pool balance. Many prime deals set the O/C target equal to the O/C floor: i.e., as a percentage of the initial pool balance. Other deals have O/C that grows to a target that is set relative to a set percentage of the current receivables balance. The O/C in this case is allowed to amortized in dollar terms, but once the floor is achieved, and assuming it is fully funded, credit enhancement grows as a percentage of outstanding collateral.|
|Look-back analysis of rating approach||Through the Great Recession, very few prime deals incurred more than 2x our base case level of losses, and none of the subprime transactions incurred more than our 'BBB' level of stress. Lower losses than expected under a 'BBB' stress scenario coupled with structural features contributed to 234 upgrades from 2007-2009. During the same time, there were only nine downgrades and no defaults.|
|Rating stability tests||After the Great Recession, we added stability tests to our rating analysis such that under a 'BBB' stress type scenario the 'AAA' and 'AA' ratings should not fall below 'AA' and 'A', respectively, in the first year and not below 'BBB' and 'BB', respectively, over the first three years. We believe this added feature has strengthened the stability of senior ratings in auto loan ABS and largely eliminated pro-rata pay transactions.|
|Changes to reflect the current environment||Given our view that we are currently in a recession, we are increasing our base case loss levels|
As the situation evolves, we will continue to monitor how it is affecting outstanding transactions and will take appropriate rating actions as we deem necessary. Given the sudden and steep shock to the economy due to COVID-19 pandemic, February performance, as provided in the March distribution reports, does not reflect the weakening economy. While we expect March performance, reflected in the mid-April distribution reports, to be a bit more telling and start to provide a picture of how the transactions are performing, we do not expect it to provide a complete picture. The first half of the month was strong due to personal tax refunds: Many of the effects of COVID-19 on the economy where not felt by most individuals until the second half of March.
Other Considerations And Concerns (Things We're Watching)
The current COVID-19 situation is raising a number of simultaneous serious considerations that we've never envisioned. We've tried to note many of these below, but surely given the rapidly evolving situation, we probably haven't considered all of them.
Workforce safety, availability, and morale
As the coronavirus spreads, sickening and killing more people, it could temporarily affect auto finance companies' staffing levels. Further, with school-age children home and day care facilities closing, parents' effectiveness and focus working from home (even if their employer's technology allows them to do so) can be affected. Even under best-case work-related scenarios, collection effectiveness is likely to be impaired as employees are distracted by more important personal concerns.
Finance companies' access to capital
Given investors' flight to quality and "risk-off" appetite, spreads have widened tremendously in the ABS market. Even with benchmarks being low, many issuers are likely to see their funding costs rise, which will lead to lower excess spread and necessitate higher levels of credit enhancement. Those companies that don't have adequate capital to cover higher required credit enhancement levels in their ABS deals could, at minimum, be forced to lower origination volumes. Worse, thinly capitalized independent finance companies could default on their warehouse facilities and face a liquidity squeeze. This could eventually lead to industry consolidation, especially in the subprime auto sector, just as we saw during the Great Recession.
Several states have ordered their residents to remain at home due to the COVID-19 pandemic. This poses challenges for auto finance companies whose collectors worked in large call centers. Even certain offshore call facilities have been closed to stop the virus' spread. Last week, many finance companies were enacting emergency plans and equipping their staff with computers and access to company networks that would allow them to continue to do their jobs remotely. There will be disruptions in collection and servicing continuity as these plans are implemented and carried out. These new processes will test the companies' internal networks with respect to load capacity and the effectiveness of managing a large collection staff remotely. Other operational challenges will include the dependence on other parties/vendors that may be closed for business, such as repossession agents and vehicle auctions.
Investment-Grade Auto Loan ABS Are Likely Protected
The sudden and steep shock to the economy due to the COVID-19 pandemic will, in our view, negatively affect auto loan ABS performance. As a result, for new auto loan ABS, we are modifying some of our cash flow assumptions and increasing our stress scenarios at the 'BBB' and lower rating levels.
Currently, we believe most investment-grade auto loan ABS are well protected. The speculative-grade classes, which are concentrated in subprime auto loans, are, in our opinion, more susceptible to downgrade and default. This is our current view based on a recovery beginning later this year or early next year due to fiscal stimulus programs and business activity resuming after the pandemic has subsided. However, this view could quickly change if unemployment remains high for an extended period. If this were to occur, the investment-grade classes would also be more vulnerable to rating downgrades.
- Investigating U.S. Auto Loan Credit Performance During Economic Downturns, 1925-2010, Jan. 5, 2011
This report does not constitute a rating action.
|Primary Credit Analyst:||Amy S Martin, New York (1) 212-438-2538;|
|Secondary Contacts:||Jennie P Lam, New York (1) 212-438-2524;|
|Kenneth D Martens, New York (1) 212-438-7327;|
|Steve D Martinez, New York (1) 212-438-2881;|
|Anaytical Manager:||Frank J Trick, New York (1) 212-438-1108;|
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