By Rosemary Kelley, senior director, Kroll Bond Ratings

Subprime auto loan asset-backed securitization has reported strong performance throughout the past few years in stark contrast to the subprime mortgage sector. Investor demand for both prime and subprime auto ABS has been very strong, particularly for senior note classes, as investors have benefitted from good performance. Auto ABS represented the largest segment of ABS issuance in 2011 with $67 billion (57%) of total issuance and is expected to be the largest sector in 2012. In 2011, subprime auto ABS, represented by nine issuers, and has accounted for $12.8 billion or approximately 19% of total auto ABS issuance. This stable performance and healthy operating margins have attracted attention from several private equity firms who have invested in six subprime lenders over the past few years. The continuation of this positive story in 2012 will depend on a variety of factors discussed herein.

The graph below illustrates the performance of subprime auto ABS by vintage year based on cumulative net losses. Although relatively stable, this graph illustrates that there has been some variability in loan performance for subprime ABS over the last 12 years. Not unexpectedly, there was some deterioration in performance for the 2006 through 2008 vintages as the recession occurred during the peak loss period for these vintages. The 2009, 2010 and 2011 vintages performed significantly better and are tracking more closely with earlier vintages, which had lower ultimate loss levels.

There are several reasons for subprime auto loans’ relative strong performance: 1) auto loans are a short-term asset class, so the feedback loop on performance trends is relatively quick; 2) subprime auto lenders were more disciplined regarding credit underwriting going into the recession than subprime mortgage lenders; 3) competition in subprime auto lending declined at the start of the recession due to consolidation in the industry; 4) subprime auto loans have higher expected losses than prime auto loans but less volatility; 5) the used vehicle market has been strong since the end of 2008 resulting in higher recovery rates and lower loss severities; and 6) auto loan ABS transactions are structured to deleverage over time.

Since auto loans are a short-term asset class, issuers are able to respond quickly to deterioration in asset performance by adjusting underwriting standards and the pricing of their loans. Early in the recession, many subprime originators had scaled back on origination volume in part due to reduced liquidity available to them. In addition, underwriting standards were tightened considerably on loans originated in 2009 – 2011 in response to the economic downturn, which resulted in significantly better loan performance. The short-term nature of this asset class also allows credit providers and rating agencies to quickly incorporate deterioration in performance into increased loss expectations, which translates into higher credit enhancement levels.

Even prior to the recession, subprime auto originators were more disciplined in underwriting standards, loan terms and verification procedures than subprime mortgage originators. For example, most subprime auto lenders perform a verification of the borrowers’ information including residence, income and employment while subprime mortgage lenders tended to rely on stated income levels. Loan terms for subprime auto have remained fairly consistent over time and loan structures are pretty straightforward with fixed-rate, simple interest loans and maturities typically of 72 months or less.

Over the past several years, following the start of the recession, the subprime auto industry faced less competition among loan originators as a result of consolidation, which also contributed to better performance as lenders were not competing aggressively for business. Some lenders, including Triad Financial, HSBC and Citi Financial, exited the space and sold their portfolios to other companies. Limited liquidity for many players also resulted in reduced origination volumes for many of the remaining lenders. The liquidity concerns have eased somewhat for many players and, during 2011, the trend in consolidation has reversed course as more lenders have started entering this space or expanding their lending which is not negative per se unless competition increases to such an extent that it causes lenders to give up underwriting discipline in order to compete for business.

Relative to loss severity, while subprime auto loans have higher absolute levels of losses than prime auto loans, the loss levels have proven to be less volatile over time. This is partly due to the smaller percentage impact of rising losses on a larger base. For example, a 1% change in losses is much more significant on a 2% base case in a prime auto transaction than it is on a 12% base case in a subprime deal. Higher cumulative losses in subprime transactions are not surprising considering the credit profile of the obligors. Subprime obligors normally have less financial flexibility available to them and may have less stable employment situations. In addition, most subprime auto loan pools do not have a high proportion of homeowner borrowers, but rather obligors whose largest asset is their automobile. In recent years, this has actually been a positive for subprime auto pools, as homeowners generally have experienced a larger shift in their financial flexibility given the burdens of mortgage debt, the reduction in credit availability and the corresponding negative wealth effect due to the housing market decline. Moreover, because autos are a depreciating asset and are thus not expected to appreciate, subprime auto did not experience a bubble in asset values as did residential real estate.

Also with regard to losses, the strength of the used car market since the end of 2008 as seen in the Manheim used car index depicted in the graph below, has mitigated loan losses. Prices did drop dramatically from August to November 2008 due to the recession and concerns over the impending bankruptcies of GM and Chrysler; however, they rebounded quickly and have been strong throughout 2011. Demand for used cars has increased since the recession as more buyers have turned to used vehicles than had previously been the case. In addition, the supply of used vehicles has been limited as there are fewer vehicles coming off lease, fewer vehicles coming from rental fleets as the rental car companies are managing smaller fleets and keeping vehicles longer, and fewer vehicles available for trade-in as new vehicle sales declined and have remained at lower levels than those prior to the recession. While there clearly has been some volatility in used car prices, losses in ABS transactions have generally been adequately covered by available credit enhancement. Nonetheless, as new car sales increase with the easing of recessionary pressures, the positive trend in used car prices could start to soften.

Lastly, in terms of transaction structure, auto loan ABS deals are structured to de-lever over time. These transactions are normally sequential pay structures, with the senior class receiving all principal payments until they are retired before the subordinated classes receive any principal payments. Credit enhancement is comprised of overcollateralization, subordination of junior classes, a reserve account (or letter of credit) and excess spread as the rate on the subprime assets normally exceeds the rate on the notes. Excess spread is also provided by receivables resulting in additional overcollateralization to the transaction. Credit enhancement builds as the senior classes amortize and the subordinate class amounts remain outstanding. Additionally, the reserve account (or letter of credit) is normally a fixed dollar amount that grows as a percentage of the remaining note balance.

Subprime Auto Story Attractive To Private Equity

The positive performance story and potential for good returns have made subprime auto lenders an increasingly attractive investment opportunity over the past year. KBRA has noted an influx of capital, particularly from private equity, as can be seen in the purchase of equity interests in several subprime auto finance companies. There are start-up firms such as CarFinance Capital that was funded by Perella Weinberg and is run by a management team from Triad. There have also been reports of additional private equity investments in subprime auto lenders.

The influx in capital can be a positive to the extent that it provides lenders with funding and the ability to grow their businesses. However, the increase in capital available and the increase in competition may place pressure on companies to loosen credit standards in an effort to grow.

Will This Positive Story Continue In 2012?

The continuation of this positive story for subprime auto ABS will depend on a variety of factors. The economy will be of primary concern as unemployment is a big driver of losses in subprime auto loans. The economic outlook is challenging for 2012, particularly given the ongoing concern over the potential impact of the European sovereign debt and financial crisis on the U.S. economy.

The ongoing strength of the used car market will continue to mitigate the severity of loan losses. Although the used car market looks high relative to historic periods, as can be seen in the Manheim used car index above, we anticipate that used car prices will remain strong over the next year. The supply of used cars remains limited, as there are fewer vehicles entering the used car market due to lower new car production, lower lease rates, reduced new car sales and smaller rental fleets. KBRA will continue to monitor longer-term trends and the potential for cyclical softening in used car prices.

Subprime lenders have been able to navigate through an unfavorable economic and unemployment environment over the past few years. They tightened underwriting standards early in the recession and maintained relatively tight standards over the past few years. Although there has been some loosening of underwriting standards over the past year, this is not surprising given the extreme degree to which lenders had cut back on lending and tightly reined in their underwriting standards for loans. In 2012, KBRA expects auto lenders to continue to show discipline in underwriting; however, the increase in competition and potential desire for growth will need to be monitored carefully.

Potential risks can be seen by looking at some of the lessons learned by the subprime auto industry in prior cycles. In the mid-to-late 1990s, competition caused auto loan originators to loosen underwriting standards in order to drive growth in originations. In addition, some of these firms were start-ups with limited financing sources. Lastly, some of these firms increased originations without building adequate servicing and back-end operations to manage this growth. This confluence of factors caused some firms to file for bankruptcy and caused significant consolidation in the industry during this period.

Today, there are a number of subprime auto lenders and management teams who have a good track record of originating and servicing subprime auto loans through several business cycles. These lenders understand the risks associated with subprime lending and should be able to manage those risks through proper underwriting, pricing and servicing of loans. KBRA believes the proper management and servicing of loans in subprime auto lending is critical due to the higher absolute level of losses. The ability of ownership and management to draw on their successful experience and benefit from the lessons of past cycles of excessive growth as they build and expand their businesses will be critical to the continued success in the subprime auto sector.