When assessing the strength of the auto finance industry, it’s often helpful to separate actual performance from the ratings on the ABS markets, said John Bella, managing director of structured finance asset-backed securities for Fitch Ratings.
There are several trends Fitch Ratings identifies that could impact performance, including a worsening of the depreciation rate in used-vehicle values, lengthening loan terms, and the possibility of merger and acquisition activity. However, those factors are not anticipated to lower ratings on the secondary market.
In fact, S&P Global Ratings has issued 881 upgrades and no defaults or downgrades on the subprime auto ABS deals it’s rated from 2004 to present. However, the company ran a stress test simulating what another financial crisis-like event would look like today and found that subprime losses would rise 1.67 times higher than S&P’s baseline expectations for the economy. So while the markets are stable, there are certainly economic factors to watch for.
“Yes, losses are going up from 2015 and 2016, and are even approaching recessionary levels,” Amy Martin, S&P’s senior director, told Auto Finance News. “But you have to look at it relative to what’s happening with the ratings, and the ratings are very stable.”
Here are six trends to watch in the ABS market, as gathered from AFN’s conversations at ABS East 2017.
It’s not so much that there is new regulation that lenders should be wary of, but rather the lack of new regulation on the secondary market is bringing a breath of stability, analysts told AFN.
Earlier this year, issuers were worried about risk retention and Reg AB II, which requires that public deals disclose asset-level data about the borrowers in the pool. Yet, after two years of readying implementation, it seems the largest players have adequately adjusted and it has not impacted the rate of issuances.
Reg AB II may still be a hurdle for first-time issuers looking to enter the market, or for lenders who have previously filed 144A private deals and are looking to go public, S&P’s Martin said. But on the whole, she — nor any of the other major rating agencies — could identify and anticipated ABS regulation on the horizon.
In five years time, that asset-level data will provide researchers with new data points to identify more in-depth trends, such as which lenders are engaging more deeply with risk layering, said JingJing Dang, vice president and senior credit officer at Moody’s Investors Service. But that data has to accumulate over time in order to draw conclusive trends.
The most discussed topic in auto ABS this year by far was the impact of used-vehicle prices.
“The sad story is that the recovery picture is hard to handicap,” Fitch’s Bella said. “It’s only going to get worse or stay in the headlines negative.”
Delinquencies and losses are already near peak highs coming up against the recessionary levels, and a lower residual value return will only continue to push those losses higher.
“On the severity side there are really two drivers of why the losses in both prime and subprime are going up,” said Hylton Heard, senior director of structured finance and asset-backed securities for Fitch Ratings. “First, is just weaker performance from the credit quality in the 2013 through 2015 vintage deals. Second, the bigger driver, is that severity is going up given the decline in vehicle values.”
Lenders may see this oversupply in the market as a reason to lax credit underwriting standards and push volume, especially among captive financial institutions who may be pressured by the manufacturers, said Phoebe Xu, senior vice president of asset-backed securities at Morningstar Credit Ratings.
“We’ve seen that the price of the used cars has declined and the number of off-lease used cars is increasing, so there is some concern about if the auto lenders are using underwriting criteria to get rid of inventories by the end of the year,” she said. “When you have a manufacturer behind you, the lender has more incentive to move sales by the end of the year before the new model is coming to market.”
Depreciating vehicle values could push prime auto ABS annual losses above 1% in the coming year, up from around 0.68% today, Heard said. Yet, lenders are anticipating this and structuring their deals appropriately to account for the increased risk, he added.
The used-vehicle depreciation trend is naturally tied to the record level of off-lease vehicles. The lease volume is only going to increase as new-vehicle sales decrease and OEMs look to push the oversupply through lower monthly cost lease deals, Heard said.
“With less new sales there are going to be more vehicles coming from the lease returns which are 8% above last year, and next year it should rise another 7%,” he said. “So there is a ton of used supply coming and that’s how pressure is going to continue.”
Moody’s is expecting a high level of off-lease volume at least through 2019, which is a “fundamental challenge to the used-vehicle market,” Dang said.
She has observed some “promising signs” of production control from companies such as General Motors Co. and Ford Motor Co. and said that captives are trying to better support their used-car networks.
However, others such as Toyota Motor Corp. and Nissan Motor Co. have announced increases in production.
“We like to hear ‘discipline,’ but I don’t think it’s enough,” Fitch’s Bella said. “The difference in the lease market today versus pre-crisis is that back then they weren’t using lease to move on popular vehicles. They were putting cash on the hood and they were incentivizing them, but they weren’t pushing lease.”
4. Negative Equity and Longer Loan Terms
One in every three borrowers owes more on their auto loan than the vehicle is actually worth, Moody’s Jang said. That’s largely being driven by more expensive cars and lenders extending loan terms to get borrowers in an affordable monthly payment.
Loan terms have hit a record high average of 70 months, Heard said. While new technology has increased the price of cars, the problem is compounded by negative equity deals in which consumers are rolling over the excess cost of their previous loan into the new one.
“Negative equity is a gateway into buying a new vehicle,” he said. “That causes you to extend term. When you’re rolling that vehicle loan into a new loan it’s that much more expensive for the borrower. It’s exacerbating the problem and that’s why you’re getting term extended up so much — the combination of higher transaction prices and negative equity.”
S&P’s Amy Martin was expecting some mergers and acquisitions by now, but that just hasn’t happened yet.
“I don’t think there is a lot of new equity flowing into this space,” she said. “There are a lot of private-equity players that have made investments in this space going back to 2011 through 2013 and to the extent they need to continue to make capital infusions to those companies to support them I think they have. Some of them are now cashflow positive which means they don’t need outside capital and that’s a good thing. But, we’re not seeing the same capital flow into the space that we saw in 2011 through 2013.”
That lack of funding may cause some of the smaller players in the space to turn to the whole loan sales market for more liquidity, she added.
“I’ve heard a little bit about whole loan sales in the unrated market,” Martin said. “Those may be attractive because they may provide a higher net proceeds off the transaction to the lender and they are not exposed to the ongoing credit risk to that pool, except to the extent they are servicing them.”
Used vehicles are starting to depreciate across the board — and not just in the car segment anymore.
“They have declined and we expect both [SUV and car] segments to decline for the rest of the year,” Heard said.
SUVs and trucks are more expensive than cars so the impact on residual values and on the consumer will be more acute if there is some macroeconomic shift.
“What if there is a geopolitical thing that impacts fuel prices?” Bella said. “A lot of portfolios have moved to a much heavier SUV and truck concentrations, so if there is a shift in that portfolio then you’re going to have further negative impact on higher-dollar volume vehicles, so you’ll see bigger price reductions.”
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