7 Min Read
By Adam Tempkin
April 17 (IFR) - While many new subprime auto bonds are getting the highest Triple A ratings, the ratings agencies themselves admit standards are loosening - and some in the market say that needs to change soon.
Skeptical investors are increasingly warning that ratings for the white-hot asset class should become more conservative, especially regarding smaller, second-tier lenders with no long-term record in issuing asset-backed securities (ABS).
The issue is particularly pressing, as 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 data.
There was only US$18.5bn in issuance for all of 2012, and just US$11.75bn the year before that.
As supply expands, however, there is a marked difference in the quality of issuers - even among those getting similar ratings from the agencies.
"The gap between the biggest players and the smaller issuers is just massive," said John Kerschner, the head of securitized-product investing at Janus Capital Group.
"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."
The agencies insist that their ratings are rock solid.
"We are confident that the ratings will hold," said Mark Risi, a senior director at S&P, the only agency to rate all four subprime auto transactions priced in the past two weeks.
"We have never downgraded a subprime auto ABS bond for credit reasons since we started covering the sector in 1991."
But there is growing debate about whether the top-rated offerings from second- and third-tier issuers will hold up.
On a recent offering from Ohio-based Security National Automotive Acceptance Co (SNAAC), which focuses on loans to military personnel, nearly 25% of the holders of the underpinning loans have no FICO score - and thus no credit history - at all.
According to S&P, around 24% have ultra-low FICOs of between 500 and 550. And roughly 24% of the loans have loan-to-value ratios of 115% to 120% - meaning that the borrowers owe more than their vehicles are worth.
Even so, S&P rated the deal AA, while rival DBRS gave it a full AAA rating.
And Utah-based Prestige Auto - which caters to borrowers who have recently declared bankruptcy - priced a US$350m subprime auto bond this month whose senior tranches got AAA ratings from S&P and DBRS.
"We're comfortable with the stress scenarios we impose," S&P's Risi said, "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."
Credit enhancement is the buffer built into securitizations that protects senior bondholders in case the underlying loans begin to sour.
This kind of protection leads many investors and bankers to say that there is nothing particularly risky in the transactions.
"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."
For its part, Prestige said that its ABS deals have performed similarly to transactions from ABS mainstays like GM Financial and Santander.
"We have since 1996 issued more than US$2bn in subprime ABS, with no events of default or accelerations, notwithstanding the ensuing economic cycles," said Aaron Dalton, senior vice president of structured finance and business development at Prestige Financial Services.
According to DBRS, Prestige is able to calculate a more accurate debt-to-income ratio on borrowers because of the underlying bankruptcies - either because the debts have been discharged by the courts or are being repaid according to court order.
But the Prestige deal also included a prefunding account, a riskier structure that allows the purchase of additional collateral after the ABS transaction closes. The risk is that new auto loans delivered to the trust could be poorer in credit quality than those already in the pool.
At the same time, all the main agencies have recently warned about a general decline in the credit quality of collateral underpinning subprime auto deals - and each is responding differently.
Fitch and Moody's have either been deemed too conservative by issuers (and therefore not hired to rate deals) or have shied away from lesser-known or unproven issuers.
"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."
Many investors in the asset class are carrying out their own due diligence, often personally meeting with management of smaller subprime lenders to get a handle on their business models.
"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," he 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."
In recent years, private equity companies such as KKR & Co, Warburg Pincus, Centerbridge Partners and Blackstone have bought stakes in various smaller subprime auto lenders.
This increases the money available for subprime companies to loan - and at the same time increases the overall amount of leverage in the market.
Given that underwriting standards are loosening - and that yield-starved investors are more willing than ever to chase returns down the credit spectrum - it could all add up to more potential risk for investors.
"Credit rating agencies have their models and they usually work, but sometimes they're just drastically off," Janus's Kerschner said.
"For subprime auto, it's the kind of model that works - until it doesn't."