There’s a caution flag out for subprime auto loan securitizations.
The Class C tranche of Honor Finance’s HATS 2016-1 – the deal that jump-started the debate as to how low deep subprime issuances could go before subprime auto ABS’s reputation for safety would be blemished – has been downgraded by S&P and KBRA. And now, what investors looked for yesterday is likely different than what investors will look for today. Two areas to watch: the strength of management and the level of credit enhancements. Rating agencies are sensitive to both, and issuers and investors must recognize their importance to performance.
Going forward, expect investors to become more interested in specifically who the originator issuer is, the strength of its management, and its financial backing.
We’ve seen rating agencies note the impact the departure of seasoned managers can have and Honor Finance is another example. In its presale report back in December 2016, S&P noted Honor’s “longstanding and experienced management team” as a factor contributing to the strength of the HATS 2016-1 deal. So it’s not a certainty that the deal would have received the same ratings had different management been in place.
In addition, financial backing could be a significant challenge if big banks that have already pulled back from direct lending begin to pull back from indirect funding. There are already setbacks from losses incurred by private equity firms that jumped into the subprime space.
Until now, super-sized credit enhancements have protected investors and have helped garner sought-after credit ratings. But for some time now, something has seemed off about how tight spreads have been, given all the risks present in subprime lending. Sufficient credit enhancements are most often cited by investors as the reason for the dynamic, but the performance of HATS 2016-1 and downgrade of its Class C notes show how losses can creep up and even overtake enhancements meant to protect a deal’s lower tranches.
It may be a positive that the hazard is now in plain sight. There should now be some tempering of the reliance on current credit enhancement levels and the projections on which they are based. As the industry wonders which deal should be next on the watch list, Honor’s HATS 2016-1 may provide the roadmap. Comparisons and contrasts with other deals – in terms of loan attributes (e.g., FICO scores, LTVs, maturity dates), deal structures (e.g., overcollateralization, subordination), management support and actual performance trends relative to projections – will be instructive.
If subprime performance deteriorates further and projected losses increase, well then, tomorrow, new issuances are going to have to show even greater credit support to get desired ratings. Ultimately, though, ratings never guarantee a favorable outcome – it’s simply not their purpose. Fundamentals matter for ratings, but fundamentals can change.
Massimo Giugliano, counsel in the Insolvency, Creditors’ Rights & Financial Products Practice Group of Davis & Gilbert, contributed to this post.