Auto Asset-Backed Securities
Automobile loan securitization has grown at a substantial pace since the market’s inception in the 1980s because of the unique benefits they offer investors. These securities deliver a diversified pool of auto loans that provide broad diversification from a geographic and demographic standpoint, security interest in tangible collateral, and short-term exposure due to the shorter average life of the underlying loans. Unlike mortgage-backed securities, automobile loan securitizations offer stable and consistent payment streams with little impact from volatile interest rates. Investors in these securities can determine the level of credit risk they are willing to assume through the bifurcation in credit quality associated with the automobile market, specifically the prime, near prime, and subprime categories. The chart below illustrates the significant industry growth of the auto loan industry since the mid-1980s from both a size and diversification standpoint.
Auto Loan Credit Quality
Additional Types of Auto Loans
Source: SIFMA. March 31, 2019 is the most recent data available from SIFMA.
Credit Quality Differentiation
Consumer auto loans are split into categories based on the borrower’s credit worthiness, which is determined by their credit scores. While there can be some variation, automobile loans are typically categorized as:
- Prime: Greater than 680
- Near Prime: 600-680
- Subprime: Less than 600
Today, prime loans are the most commonly securitized, making up nearly 38 percent of the automobile ABS market as of March 31, 2019. The securitization of subprime loans has become much more common since their emergence in the early 1990s, when they made up just 2.2 percent of the market, reaching 10.1 percent by 2000. Today, the subprime securitization market has more than doubled to roughly 23.9 percent of the entire auto ABS market. The securitization of the near-prime market emerged in the late 1980s and peaked as a percentage of the auto ABS market in 1997 at roughly 16.7 percent. The near-prime category has been in steady decline as the market has focused more on a bifurcation of prime and subprime.
Within the auto ABS market, there are a variety of differentiating factors, with the most prevalent being the types of collateral.
Auto lease ABS are similar to auto loan ABS in that the cash flow comes directly from the borrower/lessor. The main difference is that when a customer leases a vehicle, it is purchased by the leasing company and the customer agrees to make payments to the leasing company for the use of the vehicle. This presents various levels of risk that are not associated with an auto loan purchase, including bankruptcy of the leasing company, which makes the leased vehicle subject to creditors’ claims. Another risk is the liability associated with accidents to which the customer could be considered liable, also known as vicarious liability. There are a few ways to limit these risks, which include having the titles of leased vehicles held by a third-party firm, requiring the customer to purchase insurance naming the leasing company as a beneficiary, and not accepting leases from states that extend vicarious liability to the company leasing the vehicle.
Floorplan financing is a method of financing that allows companies to make bulk purchases of inventory while using the vehicles themselves as collateral. Not only are the vehicles used as collateral, but company assets, such as buildings and property, can also be used as collateral to facilitate large purchases. It should be noted that floorplan financing is not focused solely on automobile dealership financing, but can be utilized for medium and heavy-duty trucks, school buses, truck bodies, truck and bus chassis, and trailers.
Fleet Auto ABS and Rentals
Fleet auto ABS consists of commercial vehicles, government-operated vehicles, taxi fleets, and police fleets, which can represent a large portion of a car manufacturer’s sales. The fleet leasing market in North America consists of a small number of operators and is dominated by three companies: Element, ARI and Wheels.
Rental auto ABS are focused on financing the purchase of vehicle fleets by rental car companies for the purpose of renting them to consumers on a short-term basis.
The Continued Growth of the Auto ABS Market
Though the Securities Industry and Financial Markets Association (SIFMA) includes collateralized debt obligations (CDOs) and collateralized loan obligations (CLOs) in the ABS category, for the purposes of this paper, both CDOs and CLOs will be excluded in the discussion of the ABS market. These securities utilize corporate debt as the underlying collateral, making them significantly different from the remainder of the ABS market.
The auto ABS market continues to grow at a rapid pace, rebounding from significant slowdown leading up to and through the Financial Crisis. With $121.9 billion in issuance through November 2019, the market has already eclipsed calendar year 2005’s level of $117.6 billion and is well ahead of 2018’s record-setting level of $118.5 billion. New issuance in the overall ABS market has been dominated by the auto sector, averaging 51.4% of the total monthly ABS volume since the beginning of the year. As the sector continues to grow, the average deal size also increases. Through November 2019, the average size of deals was roughly $851 million, a significant increase from the average size in 2018 ($770 million) and 2017 ($725 million).
Understanding the Structure of Auto Asset-Backed Securities
The securitized market provides portfolio managers with a wide variety of opportunities to construct portfolios that deliver alpha while mitigating risk. However, managers must dedicate time and resources to uncovering opportunities and understanding the various nuances of the asset-backed securities they are considering to ensure they are finding the best value in the market. To demonstrate the time and resources it takes to truly understand the opportunities in the auto ABS market, we’ll use Westlake Automobile Receivables Trust 2017-2 (WLAKE 2017-2), a subprime auto deal that was issued in August 2017, as an example.
For additional detail and background on the process and structure of securitization, please reference our earlier piece, Mechanics and Benefits of Securitization.
Collateral Transparency and Credit Enhancement
When new securitized issues come to market, underwriters provide detailed information on the underlying loans within the issue so that managers can gain a full understanding of the pool of assets being securitized. These details provide a better understanding of the expected cash flows as well as how the structure will handle losses. The table below illustrates some of the details available for the WLAKE 2017-2 deal.
|Average Loan Size||$11,111||New Vehicle%||4.90%||Geographic Mix|
|APR||19.58%||Used Vehicle %||95.10%||CA||20.79%|
|Original Term||53 Months||Loan to Value||106.91%||TX||16.00%|
|Remaining Term||49 Months||FICO Score||596||FL||12.92%|
Source: DBRS. Details represent a weighted average by dollar amount.
Another key component that investors consider when analyzing securities is the level of credit enhancement within an issue. Credit enhancement is a method of lowering the credit risk of securities within a pool of assets being sold to investors. There are different types of credit enhancement, but we will focus on the four most common.
Excess spread is net interest that is left over after all expenses are covered for an asset-backed security. This interest is deposited into an account and can be used to cover missed payments. This excess spread enhancement is applied to all tranches of a deal.
For the WLAKE 2017-2 example, the excess spread is 12.66 percent, which is determined by the weighted average annual percentage rate of 19.58 percent less the 4.00 percent servicing fee and an assumed blended note rate paid to investors of 2.92 percent.
The issuer agrees to put aside a small percentage (typically 1 to 2 percent) of the market value of the issue as the reserve account. These assets are used to support outstanding tranches of the issue should any disruption in cash flows impact the trust’s ability to pay its monthly obligations.
For the WLAKE 2017-2 example, the reserve account is set at 1 percent per the prospectus, which equates to $8,602,150, an amount that is put aside by the issuer.
Overcollateralization is the process by which the lender constructs the offered bonds such that they will be worth less than the actual value of the pledged assets acting as collateral.
The total deal balance for WLAKE 2017-2 is $860 million and the size of the securitization at issuance is $800 million, so the overcollateralization of the deal initiates at 7 percent.
A popular type of internal credit support is the senior/subordinated, or A/B, structure, which uses subordinated classes (B, C, etc.) as protective layers for the A tranche. If a loan in the pool defaults, any losses incurred are absorbed by the subordinated securities first. The A tranche is unaffected unless losses exceed the amount of the subordinated tranches.
The senior securities are the portion of the ABS issue that have the most credit protection, while the lower-quality (but presumably higher-yielding) subordinated classes receive a lower rating or may be unrated.
In the chart below, we break down the different types of credit enhancement. The subordination and tranche structure provides investors options within the issue, from the “front pay” bond yielding 1.45 percent with 34.50 percent support to the final tranche yielding 4.63 percent with 0.00 percent support. The lower the credit enhancement level, the less protection and more risk tied to the bond relative to tranches higher in the credit structure. The hard credit enhancement is composed of the subordination, the overcollateralization, and the reserve account. Total credit enhancement is determined by adding the hard credit enhancement and the excess spread.
Security Structure Breakdown As Of 8/10/17
|Class||Size At Issuance||Yield/ Financing Cost||S&P/DBRS Rating||Subordination||Over- Collateralization ($60,075,054)||Reserve||Total Hard Credit Enhancement||Total Credit Enhancement Including Excess Spread (12.66%)|
An investor with a shorter time horizon would most likely consider investing in the A1, A2A, or A2B tranches, sacrificing yield relative to lower tranches in exchange for a shorter repayment period and stronger credit enhancement. An investor who is seeking a longer-term investment and is willing to accept additional risk relative to the earlier tenured tranches could consider the D tranche. The difference in extending the investment by moving down the tranche structure? Utilizing an average coupon level of 2.01 percent for the A1, A2A, and A2B tranches, the benefit of owning the D tranche is an additional 1.27 percent in monthly payment but less credit enhancement (55.2 percent vs. 25.5 percent).
Finding Value and Opportunity in the Auto ABS Market
Now, we’ll examine the WLAKE 2017-2 deal as of the most recent payment period, November 2019, to see where the various tranches stand.
- The first tranche, A1, which was scheduled to pay off in August 2018, paid off in
- The two subsequent tranches, A2A and A2B, were issued with final maturities of
July 2020 and both paid off in May 2019.
- The B tranche paid off during the most recent payment period, well ahead of the
original maturity date of December 2020, which places the C tranche at the top of
the cash flow structure and puts it on pace to pay off ahead of schedule.
- An investor that purchased the C tranche at issuance bought a security that was
rated “A” by S&P in August 2017 but now owns a security that is rated “AAA” by S&P due to the payoff of tranches that were ahead in the cash flow, moving the C tranche higher in priority.
Security Structure Breakdown As Of 11/15/19
|Class||Current Size||Yield/ Financing Cost||S&P/DBRS Rating||Subordination||Over- Collateralization ($30,889,446)||Reserve||Total Hard Credit Enhancement||Total Credit Enhancement Including Excess Spread (12.66%)|
|A2A||PAID OFF||PAID OFF||N/A||N/A||N/A||N/A||N/A||N/A|
|A2B||PAID OFF||PAID OFF||N/A||N/A||N/A||N/A||N/A||N/A|
|B||PAID OFF||PAID OFF||N/A||N/A||N/A||N/A||N/A||N/A|
Understanding the structure of auto ABS issues and the nature and speed of their amortization is one of the keys to building a portfolio that can provide both a diversification and yield advantage over comparable duration securities.
Dispelling the Myths of the “Next Big Short”
Going back to the mid-2010s, auto ABS have, at various times, been touted as the “Next Big Short” and created some angst in the financial markets. “The Big Short” is a reference to the non-fiction book and movie of the same name that follows the exploits of certain investors in the financial industry that turned the Financial Crisis into a windfall for their investors by betting against the market. The term has been used endlessly as a reference for identifying, usually incorrectly, the next potential pitfall of the financial markets. In this case, various media outlets have attempted to compare the increase in the size of the ABS market to the run-up of the subprime mortgage market in the years before the Financial Crisis. The prospect of subprime auto ABS serving as the catalyst for the next financial crisis gained momentum in 2017 when Steve Eisman, who was featured prominently in “The Big Short,” made headlines when he voiced concerns about the subprime auto market. Eisman followed up these comments by acknowledging that the sector isn’t big enough to cause problems for the entire financial system, but the damage was done. Article upon article harped on the comments made by Eisman and painted a picture of overleveraged consumers pushing the auto ABS market to the brink.
Similarities to the Subprime Mortgage Market Are Minimal
While both mortgages and auto loans can be securitized, the nature of the collateral is vastly different. Mortgages that are underwritten outside of Government Sponsored Enterprises (GSEs), such as Fannie Mae and Freddie Mac, take on significant credit risk by loaning money to homeowners. In the years leading up to the Financial Crisis, some homeowners who operated under the mistaken belief that housing prices only go up utilized the equity in their home to invest in the housing market and buy additional homes as investment properties. Mortgage underwriters, unfazed by overleveraging the consumer, continued to issue mortgages, package them into securitizations, and sell them in the market, unconcerned about the future viability of the loans once they were sold.
Conversely, the auto ABS market deals with a depreciating asset. For a new car, the standard rule of thumb is that a car will lose roughly 11 percent of its value the moment you leave the dealership and 15 to 20 percent of its value each year going forward.¹ For used cars, the impact isn’t as pronounced, as the biggest impact of depreciation occurs early in the life of the car, but it still continues to lose value. The important distinction is that car owners aren’t using equity in their cars to purchase additional cars, as they don’t have enough equity to offset the value of the loan and, unlike housing, the expectations for appreciation in the value of a car is zero.
Given the nature of the collateral as well as the various levels of investor protection, the similarities between the housing market and auto market securitization are minimal. However, history is the best teacher and we can look at the late 1990s as a closer comparison for stress in the auto ABS market. Growth in the subprime auto market and the emergence of inexperienced underwriters resulted in weak underwriting, losses, and consolidation in the industry. The subsequent cleansing of the auto ABS market and its participants didn’t rattle financial markets or result in a crossover to other areas of the market.
Opportunity for Diligent Managers
The Diamond Hill fixed income team is able to exploit some of the pricing inefficiencies associated with the auto ABS market through our bottom-up research analysis, along with our deep understanding of deal structures and the companies that bring them to market. Meeting with firms that issue these deals on a regular basis provides insights into the issuing firm’s history, philosophy, background, and financial stability. We combine the qualitative aspects of understanding a company with the quantitative methodology of breaking down deals to their basic components to truly understand how they are structured and where risks may reside.
Capacity discipline also plays a very important role in the ongoing management of our fixed income strategies. Our smaller size allows us to take advantage of deals that larger firms would not consider, as the size of the deal would be a negligible addition to a very large strategy. At Diamond Hill, portfolio managers are solely responsible for determining the capacity estimates for their strategies. The key consideration in estimating a strategy’s capacity is to determine what asset size may hinder our ability to add value over a passive alternative. Our portfolio managers have the authority to close their strategies before they reach an asset size where they believe that they can no longer add sufficient value.
The views expressed are those of Diamond Hill as of December 2019 and are subject to change. These opinions are not intended to be a forecast of future events, a guarantee of results, or investment advice. Investing involves risk including the possible loss of principal.