Auto Asset-Backed Securities
Auto loan and auto lease asset-backed securities (ABSs) are based on the cash flow of customer payments from a particular pool of auto loans or leases. Auto ABS form a large and liquid part of the ABS market, and unlike mortgage-backed securities, prepayment speeds are relatively unaffected by prevailing interest rates.
Auto Loan Asset-Backed Securities
Auto loan origination is categorized as being direct or indirect. In the direct lending channel, the consumer goes to a lender to get an auto loan, whereas the indirect lending channel involves the dealer as an intermediary. The borrower's interest rate is determined by credit scores, income, employment history, housing profile, and loan-to-value ratio.
Borrower credit quality is categorized according to their credit scores as being prime, nonprime, or subprime. Credit scores greater than 680 are classified as prime, nonprime scores are between 600 and 680, while subprime is less than 600. Cashing is the actual funding of the loan, and boarding is the development of the loan file and initial servicing records, most of which are stored electronically.
Servicers manage the cash flow of auto ABS, collecting and processing the payments from the loan pool to pay the investors. They also attempt to collect from delinquent borrowers. Servicers are paid a fixed fee that ranges from 0.5% to 2.0% of the pool's remaining collateral balance. Part of the credit rating of the auto ABS depends on the creditworthiness of the servicer as well as the servicer's experience in servicing auto loans and leases.
Collateral pools of prime, nonprime, and subprime loans have different rates of delinquencies, credit losses, and prepayment speeds.
Servicers are treated as a 3rd party, even if they were the originators of the loans. They must meet specified performance goals, and if they fail to meet them, they can be replaced. Servicers are paid a fixed fee that ranges from 0.5% to 2.0% of the pool's remaining collateral balance.
Securities based on a collateral pool of subprime borrowers requires greater credit enhancement than would be required of a pool of nonprime or prime borrowers for the same credit rating.
Collateral performance is affected by the economy and by conditions affecting the auto industry. When the economy slows, defaults and slow payments increase, and the resale value of repossessed vehicles declines. Adverse economic conditions can have a particular effect on the auto industry. For instance, gasoline prices have increased rapidly in the 1st half of 2008, which, in turn, has not only slowed the economy, but has depressed the resale value of gas-guzzling pick-up trucks and SUVs, while the resale price of fuel-efficient vehicles has gone up because demand had exceeded supply.
The cumulative net loss for a pool increases significantly over time for subprime borrowers, but is relatively stable for prime borrowers, while losses on nonprime pools are intermediate.
Auto loans use the absolute prepayment speed (APS) metric, whereas most other securitized assets use the conditional prepayment speed (CPR). Both prepayment speeds are listed as a percentage.
Absolute Prepayment Speed (APS) = Number Of Loans Prepaid In A Given Period / Number Of Original Loans In Pool
Conditional Prepayment Speed (CPR) = Annualized Rate Of Monthly Prepayments / Outstanding Balance At Beginning Of Period
(For more info, see prepayment models.)
Auto prepayment speeds are relatively unaffected by prevailing interest rates because of their short term and low loan balance compared to mortgages. The other reason why auto loans are not refinanced is because the value of the vehicle falls faster than the loan balance. Hence, lenders are unwilling to refinance the vehicle unless the borrower has excellent credit.
Most prepayments of auto loans occur because the vehicle was sold or traded in; the vehicle was demolished and the loan was paid off with insurance proceeds; or the servicer of the loans advanced payments for defaulted loans which the servicer expects to recover.
Ironically, subprime borrowers tend to prepay more than prime borrowers because they are paying a higher interest rate and, thus, can save more money by prepaying.
Auto Loan ABS Structures
Most auto ABS use, like most ABS, external and internal credit enhancements to achieve specific credit ratings for each of the tranches. The main external credit enhancement is the use of the special purpose vehicle to achieve bankruptcy remoteness from the originator of the underlying loans. Internal credit enhancements include the use of the senior/subordinate tranche structure, the use of reserve accounts and excess spread.
The amount of credit enhancement required is determined by the credit rating agencies that are consulted in structuring the deal. The most important factors are the originator's underwriting criteria and the servicer's track record. Key considerations of both originator and servicers are the experience of management, their policies and procedures, the firms' capital structure and creditworthiness, and their plans for growth.
Auto ABS are also subject to cleanup calls. When the outstanding balance of the deal falls below a certain level, typically 10%, the servicer may call all the remaining bonds to end the deal, because servicing the deal has certain fixed costs that become greater relative to the remaining declining income.
Valuation and Market Risks of Auto Loan and Lease Asset-Backed Securities
The main market risks of auto loan and lease ABS are credit rating changes and liquidity. Like any fixed-income security, the value of the security depends on its credit rating. If the issuer is downgraded, then the security will drop in value. However, most auto ABS are issued with a AAA rating, with very few downgrades in the past. Most of the downgrades have occurred with auto ABS based on subprime pools.
Because the auto ABS market is very large, these securities have very high liquidity. However, liquidity of certain auto ABS can be impacted if their structure is too complex for most investors to comprehend, or if the underlying pool of loans or leases is from subprime customers. Auto lease ABS also sell at a discount because of the unknowable residual risk.
There are 2 sources of uncertainty concerning the pricing of auto ABS in the market, and both relate to the uncertain average lifetime of the security. The 1st source is the market's assumption that auto ABS is prepaid at a constant rate of 1.5%. However, there is always a ramp-up period when the prepayment rate steadily increases until it reaches a plateau. Hence, securities with short average lifetimes will probably have a longer lifetime than projected, which could cause buyers to pay more for the security than it would otherwise be worth.
The 2nd factor that could reduce the value of the security in the secondary market is the potential for a cleanup call. Historically, most servicers have exercised their cleanup-call right when the outstanding balance of the underlying pool has dropped below 10%, because the smaller income from the smaller balance becomes less than their fixed costs in servicing the securities. Servicers exercise this right regardless of whether the securities are trading at a premium or discount in the secondary market, because the market price is unrelated to their servicing costs. This, in effect, shortens the average life of the securities based on the pool. Hence, most buyers in the secondary market will price the ABS at its yield to call, as if it will be called at the earliest possible time, which reduces their price in the secondary market, and unlike corporate bonds with specified earliest call dates, the call date would have to be estimated since the call option depends on the size of the underlying pool rather than the date.