auto loan abs manual

This report is available on wellsfargo.com/research and on Bloomberg WFSP

October 27, 2010

Structured Products Research

Please see the disclosure appendix of this publication for certification and disclosure information

Americans love their cars, and auto loans have been one of the mainstays of the consumer asset-backed securities (ABS) market since the market’s inception in 1985. Over the past 25 years, the auto loan ABS sector has seen steady growth, as securitization has proved to be an attractive and efficient source of funding consumer auto loans. Despite the recent recession, decline in vehicle sales, and troubles in capital markets, auto loan ABS have become the new benchmark sector for the consumer ABS market. This report offers a guide to understanding auto loan ABS, its structure and valuation. Table of Contents Auto Loan ABS Issuance Page 2

Auto ABS Issuance Page 3

ABS Outstanding by Sector Page 3

Auto Loan ABS Issuers Page 4

Deal Structure Page 5

Pricing Benchmarks Page 6

Payment Windows Page 6

Credit Enhancement Page 6

Clean-Up Call Page 7

Prepayment Rate Conventions Page 8

Cash Flows 0

Collateral Profile and Credit Performance Page 11

Rating Agency Review Page 13

Surveillance of Auto ABS Investments Page 14

Relative Value in Auto Loan ABS Page 14

OAS Valuation Page 16

Summary Page 18

Asset-Backed Securities Research

John McElravey, CFA, Senior Analyst [email protected]

704-715-7615

Zachary Bolster, Associate Analyst [email protected]

704-715-8382

Asset-Backed Securities Manual: Auto Loan ABS A Primer for Understanding Credit, Structure and Valuation

Asset-Backed Securities Manual: Auto Loan ABS WELLS FARGO SECURITIES, LLC October 27, 2010 ASSET-BACKED SECURITIES RESEARCH

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Auto Loan ABS Primer Americans love their cars, and auto loans have been one of the mainstays of the ABS market since the market’s inception in 1985. Over the past 25 years, the auto loan ABS sector has seen steady growth, as securitization has proved to be an attractive and efficient source of funding consumer auto loans. Despite the recession, decline in vehicle sales, and troubles in capital markets, auto loan ABS have become the new benchmark sector for the consumer ABS market. This report offers a guide to understanding auto loan ABS, its structure and valuation. Auto ABS Issuance Growth in auto loan ABS coincided with the recovery in the auto market following the 1991 recession. U.S. vehicle sales recovered to about a 15 million unit annual rate from 1994 to 1998, and then total vehicle sales increased to an average of nearly 17 million units from January 2000 to December 2007. The onset of the recession in December 2007 and the financial difficulties of the Detroit Three automakers pushed sales below 10 million units in early 2009, though the auto market seems to have recovered to an 11 million-12 million-unit range (Exhibit 1) beginning in 2010.

Exhibit 1: Total U.S. Auto Sales

8

10

12

14

16

18

20

22

Jan-9

0

Jan-9

1

Jan-9

2

Jan-9

3

Jan-9

4

Jan-9

5

Jan-9

6

Jan-9

7

Jan-9

8

Jan-9

9

Jan-0

0

Jan-0

1

Jan-0

2

Jan-0

3

Jan-0

4

Jan-0

5

Jan-0

6

Jan-0

7

Jan-0

8

Jan-0

9

Jan-1

0

Millions

of

Units

(SAAR)

Sources: Department of Commerce, Bloomberg.

The auto finance market has been predominantly based on auto loans to prime quality borrowers originated by the captive finance companies of large automakers. These loans have provided a steady stream of collateral to securitize. However, as investors showed growing acceptance of securitization during the 1990s, the economics of ABS brought new auto issuers into the market that included smaller specialty finance companies as well as lenders to nonprime borrowers. The development of a deeper subordinated bond market helped increase the advance rates for issuers and created ABS for more credit investors. After steady increases from 1995 to 1999, led mainly by nonprime auto ABS, issuance jumped in 2000 (Exhibit 2). This increase was driven by a number of factors, including the growing popularity of sport utility vehicles, deeper U.S. market penetration by foreign automakers and a wider variety of financing options such as a wider use of leases and longer loan terms to keep monthly payments lower.


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Exhibit 2: Auto ABS Issuance

0

10

20

30

40

50

60

70

80

90

100

1985

1987

1989

1991

1993

1995

1997

1999

2001

2003

2005

2007

2009

Billion $

Lease

Nonprime

Prime

Source: Asset-Backed Alert.

The outstanding value of auto ABS peaked at about $234 billion in 2003 and $232 billion in 2004. The total amount of auto ABS declined after 2004, as existing deals paid down faster than new deals were created (Exhibit 3). This trend resulted from a number of factors. First, low short-term interest rates created an environment where auto loans could be financed at lower cost with CP issued by asset-backed commercial paper conduits than in the term ABS market. Second, problems at the Detroit Three automakers forced them to curtail ABS issuance. Finally, consumers, to some extent, substituted mortgage debt (with its tax-deductible interest) for other types of consumer borrowing during a period of record-low mortgage rates. This allowed some big-ticket purchases, like cars and trucks, to be financed on a tax-advantaged basis.

Exhibit 3: ABS Outstanding By Sector

0

50

100

150

200

250

300

350

400

450

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

Billion $

AutosCredit Cards

Student Loans

Source: SIFMA.

When credit markets seized up in 2008, auto ABS issuance, along with the rest of the ABS market, came to a standstill. Total auto ABS outstanding dropped to about $136 billion by 2009,


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and the pace of issuance more recently pushed auto loan bonds outstanding to about $140 billion through the first quarter of 2010. New regulation of securitization arising out of the financial crisis will likely increase the costs of ABS compared with other types of financing for corporations. This new environment will likely limit auto ABS issuance relative to the past. Nevertheless, auto ABS issuance should remain one of the pillars of the market as student loans shift to direct government lending and large commercial banks move away from securitization as a means of funding their credit card lending operations. Exhibit 4: Auto Loan ABS Issuers

Shelf Name Ticker

Detroit ThreeAlly Auto Receivables Trust ALLYACapital Auto Receivables Asset Trust CARATChrysler Financial Auto Securitization Trust CFASTDaimler Chrysler Auto Trust DCATFord Credit Auto Owner Trust FORDO

Foreign MakersBMW Vehicle Owner Trust BMWOTHonda Auto Receivables Owner Trust HAROTHyundai Auto Receivables Trust HARTMercedes-Benz Auto Receivables Trust MBARTMMCA Auto Trust MMCANissan Auto Receivables Owner Trust NAROTToyota Auto Receivables Owner Trust TAOTVolkswagen Auto Loan Enhanced Trust VALET

Bank LendersBank of America Auto Trust BAATHuntington Auto Trust HUNTJP Morgan Auto Receivables Trust JPMRT

Independent Finance CompaniesCarmax Auto Owner Trust CARMXUSAA Auto Owner Trust USAOTWorld Omni Auto Receivables Trust WOART

Subprime LendersAmericredit Auto Receivables Trust AMCARCPS Auto Trust CPSSantander Drive Auto Receivables Trust SDARTTriad Auto Receivables Owner Trust TAROT

Sources: Bloomberg, Wells Fargo Securities, LLC. Despite the upheaval in the auto sector and the changes in the auto finance market, the roster of auto ABS issuers has not changed drastically over the past few years. Exhibit 4 lists the major auto loan ABS issuers from the past three years. The number of deals from issuers has increased to more normal levels, with regular issuers bringing two to four deals per year. However, the size of deals has decreased sharply. In 2005 and 2006, it was not unusual to see new deals issued in the $3 billion-$5 billion range. In 2010, the largest deals have been just under $2 billion. Auto ABS issuers can be divided into five broad groups: the Detroit Three, foreign automakers, bank lenders, independent finance companies and subprime lenders. The lending arms of GM and Chrysler were sold to private-equity firms and restructured as more independent entities. Over the past several years, there has been considerable consolidation in the auto finance sector, particularly among lenders to nonprime borrowers. A number of regular ABS issuers have been


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acquired by large commercial banking firms, which has reduced their need to access the securitization market. Americredit recently announced that it would be acquired by GM and that its lending platform would be used by GM to recreate, to some extent, its former captive lending business. However, Americredit is expected to continue to make subprime loans and access the ABS market. Deal Structure Auto loan ABS are typically issued using an owner trust structure, which is a legal form that allows for a time tranching of the senior class, as well as credit tranching to issue subordinated debt. The sequential senior bonds allow issuers to tailor issuance to meet the different maturity preferences of fixed-income investors. For example, an auto owner trust may have a senior class that is divided into four sub-classes (Exhibit 5). The Class A1 tranche would be structured with a short average life and would typically meet the requirements for Rule 2a-7 eligibility so that money market investors could buy it. In addition, there would be classes with one-year and two-year average lives, as well as a last cash flow (LCF) senior bond, with an average life of three years or more. The LCF senior bond tends to have a more limited investor base than the other senior bonds because this class may have greater variability in its expected maturity. One or more subordinated classes also may be offered, usually with ratings from AA to BBB. Exhibit 5: Example Auto Loan ABS Structure

Weighted Avg. Pricing Principal Payment

Class Life (Years) Benchmark Rating Window (Months)

A1 0.3 Interp. LIBOR A1 / P1 1 - 8

A2 1.0 EDSF AAA / Aaa 8 - 16

A3 2.0 EDSF / Swaps AAA / Aaa 16 - 34

A4 3.0 + Swaps AAA / Aaa 34 - 48

B 3 to 4 Swaps Aa / AA 48 - 51

C 4.0+ Swaps A2 / A 51 - 51

D 4.0+ Swaps Baa / BBB 51 - 51

Notes: Classes C and D subject to clean-up call.EDSF used to price fixed-rate bonds with WAL < 2.0 years, swaps >= 2.0 years.WAL and payment windows are for illustrative purposes only.

Source: Wells Fargo Securities, LLC.

Other Internal Credit EnhancementCash Reserve AccountOvercollateralization

Excess Spread

Auto loan ABS may also be structured as a grantor trust in which certificates represent a proportionate beneficial interest in the trust. Principal is passed through to investors on a pro rata basis. The certificates can be tranched into senior and subordinated classes, but no time tranching is allowed. This structure is out of favor in the auto ABS sector, though other sectors such as timeshare ABS still make use of grantor trusts.


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Pricing Benchmarks Some auto ABS transactions will likely offer floating-rate securities priced off of one-month LIBOR. In the current interest rate environment, floating-rate securities are out of favor and most ABS today are priced as fixed-rate bonds. The pricing benchmarks for fixed-rate auto ABS depend on the weighted-average life (WAL) of the bond. For example, the money market tranche would be priced against an interpolated LIBOR rate. If the WAL is 0.30 years, then the yield would be based on an interpolated LIBOR rate between three months and four months. For bonds with average lives of 2.0 years or longer, the swap curve normally would be used as the pricing benchmark for the auto ABS. Bonds with average lives less than 2.0 years use the Eurodollar synthetic forward rate (EDSF), which is the rate implied by the prices of Eurodollar futures. This curve may deviate from the interpolated LIBOR rate implied by the cash market. Payment Windows Since the underlying loans make payments of principal on a monthly basis, the principal is returned to investors also on a monthly basis. This structural artifact creates a “payment window” for each of the bonds. For example, in Exhibit 5, Class A2 has a principal payment window from month eight to month 16 – a nine-month payment window. This feature is unlike credit card ABS where the bonds are structured with a bullet payment of principal at the expected maturity date. Investors generally prefer tighter principal payment windows that allow for less uncertainty as to WAL and valuation. The return of principal to investors can be affected by prepayments and defaults by borrowers, as well as the exercise of the clean-up call option by the issuer (discussed further below). The Class A2 bonds tend to be the largest class in an auto loan ABS deal, and the majority of the total amount of the bonds issued tends to be in the top of the capital structure to minimize the cost of issuance. Credit Enhancement As in any ABS deal, credit enhancement is required by the rating agencies to achieve a desired credit rating and to reduce the risk of credit writedown to the investor. The amount of credit enhancement required is typically determined as a multiple of expected baseline net losses from the pool of loans within the context of the transaction structure. (A brief discussion of rating agency criteria follows in a later section.) Auto loan ABS utilizes some combination of internal credit enhancement including excess spread, cash reserve account, overcollateralization (OC) and subordination to achieve the desired credit ratings. External credit enhancement in the form of sponsor guarantees or bond insurance may be used, but that type of enhancement has fallen out of favor as bond insurance firms have been downgraded in the financial crisis. The first line of defense against credit loss for any auto ABS deal is excess spread, which is the interest collected from the collateral pool in excess of the interest payable on the bonds plus the servicing fee. High levels of excess spread can mitigate the need for higher levels of other types of credit enhancement in a deal, such as a reserve account or OC. However, the rating agencies tend to give limited credit to excess spread because it is only available in the period in which it is generated. It generally is not stored unless a credit trigger is hit. Furthermore, poor collateral performance (high delinquencies and defaults) could place downward pressure on realized excess spread from that expected at origination. A cash reserve fund provides liquidity for an ABS deal to pay shortfalls on interest and certain principal collections. If the reserve fund is tapped, there is normally a mechanism for it to be replenished through excess spread in subsequent periods. Reserve accounts tend to be funded at the origination of the ABS transaction, with cash or eligible securities based on a percentage of the initial receivables balance. The reserve account balance may be fixed (non-declining) for the life of the deal, or it may decline as the collateral pool pays down and maintains a given percentage of the collateral balance.


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Overcollateralization is the amount of receivables that exceeds the principal amount of the bonds issued to outside investors. OC may also be thought of as the issuer’s retained, or equity, portion of the ABS deal. This extra collateral can be a relatively cost effective way for an issuer to enhance an ABS transaction. It has the added benefit of increasing the amount of excess spread. Subordination is created by prioritizing the principal payments of higher-rated notes ahead of the lower-rated notes. The rating agencies require lower amounts of credit enhancement for lower-rated bonds. In most structures, subordinated bonds are locked out from receiving principal until the bonds ahead of them in the capital structure are fully paid down. The credit enhancement percentage would increase as the senior bonds pay principal and the leverage in the deal declines. This characteristic is one of the sources of the long history of rating stability in auto ABS senior bonds and the upgrades common to subordinated auto ABS bonds. According to data from Moody’s Investor Service, the aggregate upgrade-to-downgrade ratio for auto ABS was 3.4:1 from 1986 to 2009.1 This rating-change ratio is down from 4.1:1 through 2007, prior to the financial crisis. The record of rating stability and upgrades in auto ABS is an attractive feature that indicates a superior risk/return trade-off as it has been tested through historically stressful market conditions. Clean-Up Call One of the key features in an auto ABS deal is the clean-up call because it can have an important effect on the average lives of auto ABS bonds and their valuations. The clean-up call refers to the issuer’s option to repurchase the outstanding principal balance of the remaining loans when the principal balance is paid down to a predetermined threshold amount. The threshold is typically 10%, but it can vary from that level. Many issuers have reduced their clean-up call threshold to 5% or less in recent years as their own need for liquidity has increased. We emphasize that the issuer’s call is on the collateral, and only indirectly on the bonds outstanding at the time the threshold is met. Market participants often focus on the current price or the coupon on the bonds compared with market interest rates when analyzing the possibility of a call. However, there are other reasons to exercise the clean-up call apart from interest rate movements or bond prices. As a result, we find that issuers may be more or less efficient when it comes to exercising their right to clean up an ABS auto deal. One fundamental reason to call is that there is value in the collateral pool. Reserve fund account balances can build up to a relatively high proportion of a deal’s collateral balance as the bonds amortize. The same is true for the extra loan collateral used as OC. This trapped capital could be accessed by the issuer and redeployed in other ways. An example of this situation can be found in the CARAT deals sponsored by GMAC, now Ally Financial. Prior to GM’s downgrade to below investment grade in 2005, GMAC was usually slow to exercise its clean-up call, and it often was several months beyond the threshold for it to act. At the same time, millions of dollars were locked up in the OC and reserve funds. Liquidity became a precious commodity for GMAC after its downgrade to high-yield status. At that point, GMAC became much more efficient exercising its option to clean up deals at the earliest possible date to unlock that capital stranded in its ABS deals. In addition to a capital release, the cost of servicing becomes a greater proportion of an ABS deal as the pool balance shrinks. It may be more cost efficient for the servicer to call an existing deal and redeploy that collateral in a new deal. Furthermore, reputation risk can be a motivating factor for issuers. Market convention is to price auto ABS to the clean-up call. If an issuer does not

1 This figure excludes upgrades and downgrades of bonds linked to the rating changes of monoline insurance providers in order to isolate the rating migration based on collateral pool performance, servicer stability, and deal structure.


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exercise its call, it risks having its subsequent deals price at wider spreads. A few basis points on billions of dollars can add up to real money quickly. Some transaction structures may penalize the issuer for not calling the deal on time through a step up in the coupon paid to bondholders. Despite these reasons to call, and a substantial history of exercise, investors still question issuers’ motivation for timely clean up. As a result, bonds that would be affected by the clean-up call tend to trade at wider spreads. The Class A4 senior bonds and subordinated bonds would be the bonds most often affected by the call. As a result, we believe that investors can find good relative value in auto ABS where the issuer has a well-documented history of exercising its clean-up call option and the credit performance of the collateral is stable. Prepayment Rate Conventions Prepayments present a challenge to cash flow modeling and bond valuation for auto loan ABS, just as they do for other securitization sectors. The prepayment rate convention that has been developed for auto loan ABS is the absolute prepayment speed (ABS). Historically, auto loan pools tended to demonstrate increasing prepayment rates on a CPR basis as they age. Borrowers accelerated their payments to eliminate a monthly bill or to trade in a vehicle. The ABS curve was developed to adjust for this upward trend (Exhibit 6).

Exhibit 6: Auto ABS Prepayment Convention

1.0

1.1

1.2

1.3

1.4

1.5

1.6

1.7

1.8

1 4 7 10 13 16 19 22 25 28 31 34 37 40 43 46

Months from Origination

ABS (

%)

5%

10%

15%

20%

25%

30%

35%

CPR (

%)

ABS

ABS to CPR

Source: Intex, Wells Fargo Securities, LLC

The ABS prepayment scale is calculated as the number of loans paid off each period as a percentage of the original number of loans. For example, a 1.3% ABS would imply that 1.3% of the loans in the pool at origination would have paid off in that period. For purposes of yield and average-life calculations, the original loan balance and loan rate are assumed to be equal to the averages for the pool. CPR, on the other hand, is calculated by comparing the current outstanding balance to actual monthly payments of scheduled principal and any prepayments of principal. Based on current data, however, the ABS prepayment curve may not represent trends in auto loan prepayment rates as well as it has in the past, in our opinion. Our review of actual ABS prepayment rates on auto loan deals illustrates that many issuers display an increasing ABS curve through the first 12-18 months of a deal’s life. After that, the ABS curve begins to flatten out through months 24-30, and then the curve begins to decline again during the latter stages of a deal’s life. For example, the recent prepayments of the NAROT shelf display this pattern (Exhibit 7). Furthermore, our research indicates that prepayment rates on a CPR basis would not exhibit the same strong upward trend that they have in the past.


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Exhibit 7: Average ABS Speed - NAROT

0.70

0.80

0.90

1.00

1.10

1.20

1.30

1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41 43 45 47

Deal Age (Months)

ABS (

%)

Sources: Intex, Wells Fargo Securities, LLC.

2005 - 2009 deals

Indeed, we find a flatter CPR curve compared to the theoretical expectation for many auto loan ABS deals issued in recent years based on voluntary prepayment rates. It appears that borrowers still prepay their loans more quickly as they age, and still trade in their vehicles after a few years of use. However, the rate at which that pattern occurs seems to be overestimated by the ABS prepayment convention.

Exhibit 8: Average CPR Speed -- NAROT

0

5

10

15

20

25

1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41 43

Deal Age (Months)

CPR (

%)


2005 - 2009 deals

Exhibit 8 displays the average voluntary prepayment rate on a CPR basis for the NAROT shelf from 2005 to 2009. There is an upward trend during the life of a transaction, but it occurs at a more subdued rate than that implied by an ABS curve. We prefer to view detailed auto loan prepayment rates on a CPR basis, broken down between voluntary prepayments and defaults. Issuer-specific prepayment curves may be more appropriate in some cases than generic prepayment assumptions.


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Cash Flows The intersection of credit and prepayment trends with deal structure provides the cash flow profile of an auto loan ABS deal. In most cases, the senior bonds are paid all principal collections until they are retired. Then, the subordinated bonds are paid in order of seniority until the deal reaches its clean-up call or the collateral pool runs to maturity. Exhibits 9 and 10 show the cash flow profile of the CARMX 2010-2 deal for each of the bonds issued to call and to maturity at the pricing prepayment speed of 1.3% ABS.

Exhibit 9: Principal Cash Flows to Call - CARMX 2010-2

0

100,000,000

200,000,000

300,000,000

400,000,000

500,000,000

600,000,000

700,000,000

0 3 6 9 12 15 18 21 24 27 30 33 36 39 42 45 48 51 54 57 60 63 66

Deal Age (Months)

Bond B

ala

nce

($)

C

B

A4

A3

A2

A1


Prepayment Speed = 1.3% ABS

Clean-up call exercised

Exhibit 10: Principal Cash Flows to Maturity - CARMX 2010-2

0

100,000,000

200,000,000

300,000,000

400,000,000

500,000,000

600,000,000

700,000,000

0 3 6 9 12 15 18 21 24 27 30 33 36 39 42 45 48 51 54 57 60 63 66

Deal Age (Months)

Bond B

ala

nce

($)

C

B

A4

A3

A2

A1


Prepayment Speed = 1.3% ABS


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Notice how the subordinated bonds in this example are locked out from receiving principal until the senior bonds are repaid in full. When the clean-up call is not exercised, the maturity of the subordinated bonds extends and the principal payment window widens. Part of the pricing spread concession for the bonds further down in the capital structure is to compensate for the uncertainty in maturity and payment window created by prepayment variability and clean-up call exercise. In other deal structures, subordinated bonds might receive some principal payments prior to the senior bonds being retired. This feature can be attractive for investors who prefer a shorter average life bond with an earlier return of capital. However, the deal would have to meet minimum credit enhancement requirements for this to occur, and subordination may be replaced by additions to the cash reserve account or overcollateralization through the use of excess spread. In addition, there may be triggers in the deal structure that would redirect principal cash flows back to the senior bonds in the event that credit performance of the collateral pool would deteriorate. Prior to the financial crisis in 2008, the market for subordinated bonds from auto ABS had become deeper and more liquid over time as more investors came to appreciate the risk/reward trade off. Since 2009, however, the subordinated bond market has not fully recovered. Demand is improving, but the number of investors active in subordinated auto ABS is still down from earlier years. Collateral Profile and Credit Performance Auto ABS is normally separated into three subsectors based on borrower credit quality – prime, near prime and subprime auto ABS. In general, transactions that have a high weighted-average (WA) FICO score, usually 680 or higher, and low expected delinquency and net loss rates would be considered a prime pool of borrowers. Near prime borrower pools would have a weighted-average FICO score in the 620-680 range with delinquencies and net loss rates somewhat higher than a prime cohort. The near-prime auto ABS segment has declined in importance over the past few years as several of the independent auto finance companies serving these borrowers have been purchased by larger financial firms, often commercial banks. Subprime auto ABS deals are backed by a pool of loans made to borrowers with WA FICO scores below 620, and with high delinquency and net loss rates. The FICO cut off thresholds are not hard and fast rules, but are based on guidelines developed over time by market participants. Indeed, while FICO scores may be instructive as to the general credit quality of a pool, we prefer to look to long-run trends in cumulative net loss rates as a better gauge of risk for an auto ABS issuer. Another way to view the different segments of the auto ABS market would be by the weighted-average coupon (gross WAC) on the pool of loans. For example, prime auto loan pools would likely have WACs in a range of about 5%-8%. Lenders at the lower end of this range tend to be finance companies, often captive finance companies of auto makers. Lenders at the higher end of the range tend to be commercial banks. Auto loan ABS from commercial bank sponsors have been relatively scarce in recent years. Near prime loan pools would likely have a WAC in an 8%-12% range, and subprime pools would likely have a WAC of 12%-20%+. The higher loan rates for the lower-quality pools reflect the higher risk of loss from those borrowers. It is not surprising to find that loss rates on different types of auto ABS deals vary widely as well. For example, prime auto ABS tends to have cumulative net loss rates over the life of the deal of about 1%. The range can be anywhere from 0.25% (in very good credit environments) to about 2%. Subprime loan pools have cumulative net losses in the low teens, in general, but can be as high as the low-20% area depending on the credit quality of the borrowers. Near prime auto loan pools would be expected to have losses in the mid-single-digit area.


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Exhibit 11: NAROT Cum Net Loss Rates, 2005-2009

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1 4 7 10 13 16 19 22 25 28 31 34 37 40 43 46 49

Deal Age

Cum

Net

Loss

Rate

(%

)


Prime borrowers

To compare prime and subprime auto ABS losses, we plot the cumulative net losses for Nissan (NAROT) and Americredit (AMCAR). For the NAROT trust, net losses have topped out in the 0.6%-0.8% range during the credit crunch and recession (Exhibit 11). Prime auto ABS net losses peak around month 18-24 in most cases, meaning that the cumulative net loss curve begins to flatten out at that point. The shape of this curve is fairly typical for prime auto loan pools, though the peak of the loss curve and the terminal value can vary from issuer to issuer.

Exhibit 12: AMCAR Cum Net Loss Rates, 2005-2009

0

5

10

15

20

25

1 4 7 10 13 16 19 22 25 28 31 34 37 40 43 46 49 52 55 58

Deal Age

Cum

Net

Loss

Rate

(%

)


Subprime borrowers

Subprime cumulative net loss curves are represented by the performance from 2005-2009 of the AMCAR program. Most cumulative net loss curves reach a maximum value in the 13%-15% range, except for certain more recent deals that have been affected by the recession and the distress inflicted on subprime households (Exhibit 12). Lower FICO borrowers tend to have less financial flexibility, so a job loss or other problems could lead to a default more easily than for a prime


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borrower. We also note that the loss curve is upward sloping and peaks much further out in the life of the ABS deal than does the prime loan pool. Rating Agency Review Rating agency review plays a key role in the securitization process of auto loans. In this section, we highlight some of the important factors that enter into the agency credit review. The credit performance profile of each pool is incorporated by the rating agencies into their cash flow models to determine the amount of credit enhancement required for the rating desired by the issuer. During the rating process, the agencies determine an expected cumulative net loss for the loan pool, and that loss would need to be covered by credit enhancement to some multiple of expected losses to provide a cushion to protect against bond writedowns for investors. Exhibit 13: Fitch Ratings Loss Multiples

Rating Prime Subprime

AAA 4.50x - 6.00x 3.75x - 4.50x

AA 4.00x - 5.00x 3.00x - 3.75x

A 2.50x - 3.50x 2.25x - 3.00x

BBB 1.75x - 2.50x 1.75x - 2.25x

BB 1.25x - 1.75x 1.25x - 1.75x

B 1.00x - 1.25x 1.00x - 1.25x

Multiples applied to baseline cum net loss rates.

Source: Fitch Ratings.

Collateral Type

Some of the major credit features taken into account in the rating process include obligor credit quality (based on FICO and issuer proprietary scoring models), loan-to-value (LTV) ratios, loan terms, annual percentage rate (APR), vehicle mix and characteristics such as make, model, and year, and geographic concentrations. Historical data on default rates, loss severity, net loss rates, and the cumulative net loss timing curve all play a role in the expected losses of the pool. In addition, the amount of excess spread generated, prepayment rates, the priority of payments (i.e., the cash flow waterfall) and any trigger events also help determine the amount of credit enhancement required to achieve the desired ratings. Collateral pools with different levels of expected losses would need to provide different amounts of credit enhancement to get the same rating. A subprime loan pool, because it would have higher expected losses, would require more credit enhancement to get a AAA rating than a prime loan pool would. The rating agencies would stress not just the amount of total expected losses, but also the timing of those losses. Their cash flow models would test scenarios where losses may occur early in a deal’s life, or the losses may be loaded more toward the end of the deal. As a result, the amount of seasoning, that is the average age of the loans, is a benefit to investors. A more seasoned pool means that the portfolio of loans is farther along its expected loss curve, and realized losses would be lower than for an unseasoned pool, all else being equal. The ability of a deal to withstand various loss scenarios would also depend on any triggers that might be built into the structure. For example, the structure may test for the level of delinquencies being below a certain threshold. If they are not, then cash flows may be diverted to senior bonds or excess interest may be trapped to provide extra protection for bondholders. The structural protections, credit enhancement, and excess spread generated by the pool work in concert to achieve the credit ratings on the bonds.


14

The quality of the servicer based on its ability to collect on the loans, mitigate losses, and maximize recoveries will also be a factor in the stress multiple applied to an auto ABS loan transaction. For example, low credit quality pools (subprime borrowers) generally require more intensive collection efforts than does a pool of prime borrowers. As a result, the strength and quality of the servicer may matter more in a subprime ABS deal and carry more weight when the loss multiple is applied. The financial strength, operational efficiency, and structure of the servicing platform (e.g., centralized versus decentralized) may also be considered. Surveillance of Auto ABS Investments Once an investment in auto loan ABS is made, we believe that it is important to provide ongoing surveillance on the collateral performance of the deal, particularly if the investor is buying a subordinated tranche of the transaction. Some of the key credit data that should be tracked, in our opinion, include current collateral balance, gross weighted-average coupon, the weighted-average bond coupon, annualized excess spread generated, gross default rate, net loss rate, loss severity, voluntary prepayment rate, delinquency rate/current balance, delinquency rate/original balance, credit enhancement levels, and any trigger events. Knowledge of the rating agency expectations for baseline cumulative net losses is also a useful comparison. These credit metrics, along with the history of performance on previous deals from the same issuer, should provide a relatively comprehensive picture of the credit trends in an auto loan ABS investment. Relative Value in Auto Loan ABS Auto loan ABS spreads have come nearly full circle since the onset of the credit crisis in the summer of 2007. The withdrawal of liquidity from the ABS market in late 2008 and early 2009 took spreads on AAA bonds to levels previously unheard of. In our view, this episode reinforces the idea that, despite its AAA credit rating, ABS is primarily a credit product with certain liquidity product characteristics. Demand for auto ABS remains strong as it is the most active sector.

Exhibit 14: AAA Prime Auto ABS Spreads

0

100

200

300

400

500

600

700

Jun-0

7

Sep-0

7

Dec-

07

Mar-

08

Jun-0

8

Sep-0

8

Dec-

08

Mar-

09

Jun-0

9

Sep-0

9

Dec-

09

Mar-

10

Jun-1

0

Sep-1

0

Spre

ad t

o S

waps

(bps)

1yr Prime

2yr Prime

3yr Prime


Spreads on auto ABS subordinated bonds have also recovered from their crisis levels, but the market for subordinated auto ABS is still a shadow of its former self. For example, BBB spread levels are still about 150 bps wider than they were prior to the credit crisis. This situation is in part due to reduced demand from investors that still prefer to invest in the more senior classes of


15

securitizations to reduce risk. Furthermore, it is also a function of the reduced supply of subordinated bonds that has pinched liquidity in the sector. Wider spreads have increased the cost of issuing subordinated bonds, and many issuers have preferred to retain the subordinated pieces rather than sell them into the market.

Exhibit 15: Subordinated Auto ABS Spreads

0

200

400

600

800

1000

1200

1400

1600

1800

Jun-0

7

Aug-0

7

Oct

-07

Dec-

07

Feb-0

8

Apr-

08

Jun-0

8

Aug-0

8

Oct

-08

Dec-

08

Feb-0

9

Apr-

09

Jun-0

9

Aug-0

9

Oct

-09

Dec-

09

Feb-1

0

Apr-

10

Jun-1

0

Aug-1

0

Oct

-10

Spre

ad t

o S

waps

(bps)

A Prime

BBB Prime


The spreads reported in Exhibits 14 and 15 are generic secondary spreads. In general, spreads on actual bonds from different issuers may be higher or lower than these generic levels. This spread tiering among issuers is part of the relative value analysis of auto loan ABS. One of the most important relative value factors is the quality of the originator/servicer. This viewpoint is similar to that taken by the rating agencies when they assign their risk multiple to calculate credit enhancement. Servicers with strong corporate financial profiles involve less risk than those with weaker financials and, thus, there is less risk of a servicing transfer. Banks and captive finance companies of automakers would generally price at tighter spreads than specialty finance firms. In recent years, however, bonds associated with the Detroit Three have generally traded at a concession to the bonds issued by some of the foreign automakers. Lower risk implies tighter credit spreads for the stronger servicer. In addition, issuers that come to market less often will often trade at a spread concession to more active issuers. Subprime auto loan ABS generally trades at a concession to prime auto loan ABS (Exhibit 16). This concession comes from two important sources. The timely collection from subprime obligors can be less certain than from prime obligors (higher loss rates) and that greater credit risk often translates into more servicer risk. Subprime lenders have tended to also be specialty finance firms that may have weaker corporate financial positions. In addition, the investor base for prime auto loan ABS tends to be larger, and this translates into tighter pricing spreads. The liquidity premium in prime auto ABS can be clearly seen in Exhibit 16, in our opinion, in the period covered by the credit crisis. Spreads on subprime auto ABS widened sharply early in the cycle as investor preferences moved in favor of more liquid bonds (prime auto ABS). As the crisis intensified, the spread differential narrowed when all ABS became subject to the general flight to quality out of credit-related bonds. Over time, the spread differential has narrowed once more, though it remains relatively wide compared with the pre-crisis environment.


16

Exhibit 16: Subprime/Prime Spread Differential

0

100

200

300

400

500

600

Jun-0

7

Aug-0

7

Oct

-07

Dec-

07

Feb-0

8

Apr-

08

Jun-0

8

Aug-0

8

Oct

-08

Dec-

08

Feb-0

9

Apr-

09

Jun-0

9

Aug-0

9

Oct

-09

Dec-

09

Feb-1

0

Apr-

10

Jun-1

0

Aug-1

0

Oct

-10

3-Y

r. S

pre

ad D

iffe

rential (b

ps )

Sources: Wells Fargo Securities, LLC.

OAS Valuation Another important factor affecting the relative value of auto loan ABS is the structure of the securitization and the cash flow profile of the bond. As discussed earlier, auto ABS may be structured as either a grantor trust or an owner trust, although the grantor trust is not commonly utilized as much as in the early days of the ABS market. The expected cash flows implied by the structure of the securitization significantly affects relative value. For example, auto ABS issued by a grantor trust may be tranched into senior and subordinated bonds, but no time tranching is allowed. As a result, bonds from a grantor trust are paid over the life of the deal and have “wide payment windows,” that is principal is repaid to investors over a relatively long period of time. In contrast to a grantor trust, the owner trust structure allows maturity tranching where principal payments can be directed to different classes of securities in order to create bonds with different average lives. Bonds offered by an owner trust would have tighter principal payment windows than the simple pass-through structure of the grantor trust. This feature allows issuers to create bonds that may appeal to different types of investors with different maturity needs. When assessing relative value in auto ABS, the relative merits of wider principal window bonds versus tighter principal window bonds should be considered, in our opinion. Wider window auto ABS would not “roll down” the yield curve as fast as tighter window auto ABS.2 Consequently, ABS investors should require a wider spread for a wider window bond as compensation for the lesser price appreciation caused by the slower roll down the yield curve. The spread differential between the wide window and tight window ABS should increase as the yield curve steepens, and decrease as the yield curve flattens. In addition to the structural considerations, the effect of prepayments on the average life of auto ABS should be taken into account. Like other amortizing assets, the use of the appropriate prepayment assumption is critical when pricing auto ABS. Faster-than-expected prepayments

2 Rolling down the yield curve refers to the rate at which a bond’s average life shortens as the bond ages. Assuming a static, positively sloped yield curve, a fixed rate bond will appreciate in price as it ages because the benchmark yield used to price the bond will be lower than the yield in the previous period. All else being equal, the faster a bond rolls down the yield curve, the greater its price appreciation and the greater its period total return.


17

result in a shorter average life, and slower-than-expected prepayments result in a longer average life. As noted earlier, there may be differences between the prepayment speed used for pricing a new issue bond and the actual prepayments experienced by the pool. For example, most auto ABS have been paying more slowly than expected over the past two or three years due to the weak economy and lower vehicle demand from consumers. The effect of the timing of cash flows, as well as the level of interest rates and shape of the yield curve, play key roles in the relative value of auto loan ABS. The most commonly used valuation framework to compare the equivalency of different amortizing bond structures is the Z-spread, or zero-volatility option adjusted spread (OAS) analysis. Also referred to as a static spread, this analysis views the cash flows of an amortizing structure as a series of zero-coupon cash flows. Using the basic bond pricing formula, it represents the constant spread over the spot rate curve that equates the present value (PV) of a bond’s cash flows to the current price of the bond and accrued interest. The spot rate curve used for discounting the cash flows may be derived from any term structure. Typically, either the U.S. Treasury or U.S. dollar swap term structure is used to determine the spot rate for discounting. Exhibit 17: Z-Spread Analysis

Cheap Cash Flows PVSpot Rate > PVSingle Rate

Single Discount

Rate

Average Life

Spot Rates

Z-Spread

Nominal Spread

Rich Cash Flows PVSpot Rate < PVSingle Rate


Exhibit 17 provides an illustration of the Z-spread analysis. In the case of an upward sloping yield curve, cash flows occurring earlier than the pricing benchmark are undervalued when discounted at the benchmark yield plus the nominal spread. By extension, the cash flows occurring later than the pricing benchmark are overvalued by the same discounting scheme. The Z-spread analysis provides a framework under which cash flow valuations can be normalized and compared. If the Z-spread is less than the nominal spread, then a greater proportion of the cash flows are overvalued given the shape of the pricing curve and the timing of the cash flows. Conversely, if the static spread is greater than the pricing benchmark, then a greater proportion of the cash flows are undervalued given the shape of the pricing curve and the timing of the cash flows.


18

Changes in the shape of the pricing curve can also affect the valuation of cash flows. For example, a flattening of the pricing curve led by the front end of the curve (higher short-term rates) decreases the extent to which the early cash flows are undervalued. Similarly, a steepening of the pricing curve led by the front end (lower short-term rates) increases the extent to which the early cash flows are undervalued. Such changes can affect both spread differentials and the expected total return of tighter window securities (where principal payments are locked out) relative to wider window securities. Total return analysis can further help to quantify both relative value and the impact of changes in the shape of the pricing curve on investors’ expected holding period returns. The two major components of total return are price changes due to movements along the yield curve and coupon income. When the yield curve is flatter, income from coupon is a bigger proportion of the total return. When the yield curve is steeper, price appreciation from rolling down the yield curve is a bigger proportion of the total return. For auto loan ABS, the average lives tend to be relatively short – generally inside of four years. The coupon income often plays a larger role in the total return of auto loan ABS. Summary The auto loan ABS sector has long been one of the mainstays of the consumer ABS market, being one of the earliest asset classes tapped for securitization. Overall issuance has coincided with the fluctuations in auto sales and the evolution of financing options. In the aftermath of the credit crisis, auto loan ABS has taken the position as the largest sector based on new issue volume. The subordinated bond market, however, has yet to regain the depth or liquidity it had in prior years. Nevertheless, credit performance of auto loan ABS has been very good throughout the credit cycle. In our view, the auto loan ABS sector should be viewed as the new benchmark sector for consumer ABS.

DISCLOSURE APPENDIX

Additional information is available on request.

This report was prepared by Wells Fargo Securities, LLC.

About Wells Fargo Securities, LLC Wells Fargo Securities, LLC is a U.S. broker-dealer registered with the U.S. Securities and Exchange Commission and a member of the New York Stock Exchange, the Financial Industry Regulatory Authority and the Securities Investor Protection Corp. Important Information for Non-U.S. Recipients EEA The securities and related financial instruments described herein may not be eligible for sale in all jurisdictions or to certain categories of investors. For certain non-U.S. institutional reader (including readers in the EEA), this report is distributed by Wells Fargo Securities International Limited (“WFSIL”). For the purposes of Section 21 of the UK Financial Services and Markets Act 2000 (“the Act”), the content of this report has been approved by WFSIL a regulated person under the Act. WFSIL does not deal with retail clients as defined in the Markets in Financial Instruments Directive 2007. This research is not intended for, and should not be relied upon, by retail clients. The FSA rules made under the Financial Services and Markets Act 2000 for the protection of retail clients will therefore not apply, nor will the Financial Services Compensation Scheme be available. Australia Wells Fargo Securities, LLC is exempt from the requirements to hold an Australian financial services license in respect of the financial services it provides to wholesale clients in Australia. Wells Fargo Securities, LLC is regulated under U.S. laws which differ from Australian laws. Any offer or documentation provided to Australian recipients by Wells Fargo Securities, LLC in the course of providing the financial services will be prepared in accordance with the laws of the United States and not Australian laws. Hong Kong This report is issued and distributed in Hong Kong by Wells Fargo Securities Asia Limited (“WFSAL”), a Hong Kong incorporated investment firm licensed and regulated by the Securities and Futures Commission to carry on types 1, 4, 6 and 9 regulated activities (as defined in the Securities and Futures Ordinance, “the SFO”). This report is not intended for, and should not be relied on by, any person other than professional investors (as defined in the SFO). Any securities and related financial instruments described herein are not intended for sale, nor will be sold, to any person other than professional investors (as defined in the SFO). Japan This report is distributed in Japan by Wells Fargo Securities (Japan) Co., Ltd, a Japanese financial instruments firm registered with the Kanto Local Finance Bureau, a subordinate regulatory body of the Ministry of Finance in Japan, to conduct broking and dealing of type 1 and type 2 financial instruments and agency or intermediary service for entry into investment advisory or discretionary investment contracts. This report is intended for distribution only to professional customers (Tokutei Toushika) and is not intended for, and should not be relied upon by, ordinary customers (Ippan Toushika). Important Disclosures Relating to Conflicts of Interest and Potential Conflicts of Interest

Wells Fargo Securities, LLC may sell or buy the subject securities to/from customers on a principal basis or act as a liquidity provider in such securities. Wells Fargo Securities, LLC does not compensate its research analysts based on specific investment banking transactions. Wells Fargo Securities, LLC research analysts receive compensation that is based on and affected by the overall profitability of their respective department and the firm, which includes, but is not limited to, investment banking revenue. Wells Fargo Securities, LLC Fixed Income Research analysts interact with the firm’s trading and sales personnel in the ordinary course of business. The firm trades or may trade as a principal in the securities or related derivatives mentioned herein. The firm’s interests may conflict with the interests of investors in those instruments. For additional disclosure information please go to: www.wellsfargo.com/research. Analyst’s Certification The research analyst(s) principally responsible for the report certifies to the following: all views expressed in this research report accurately reflect the analysts’ personal views about any and all of the subject securities or issuers discussed; and no part of the research analysts’ compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed by the research analyst(s) in this research report.

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This report is for your information only and is not an offer to sell, or a solicitation of an offer to buy, the securities or instruments named or described in this report. Interested parties are advised to contact the entity with which they deal, or the entity that provided this report to them, if they desire further information. The information in this report has been obtained or derived from sources believed by Wells Fargo Securities, LLC, to be reliable, but Wells Fargo Securities, LLC does not represent that this information is accurate or complete. Any opinions or estimates contained in this report represent the judgment of Wells Fargo Securities, LLC, at this time, and are subject to change without notice. For the purposes of the U.K. Financial Services Authority's rules, this report constitutes impartial investment research. Each of Wells Fargo Securities, LLC, and Wells Fargo Securities International Limited is a separate legal entity and distinct from affiliated banks. Copyright © 2010 Wells Fargo Securities, LLC.

SECURITIES: NOT FDIC-INSURED * NOT BANK-GUARANTEED * MAY LOSE VALUE

WELLS FARGO SECURITIES, LLC FIXED INCOME RESEARCH

Diane Schumaker-Krieg, Managing Director, Global Head of Research & Economics [email protected] (704) 715-8437 (212) 214-5070

Structured Products Research Marielle Jan de Beur, Managing Director Head of Structured Products Research [email protected] (212) 214-8047

CMBS and Real Estate Research (704) 715-8425

Glenn M. Schultz, CFA, Managing Director Head of Residential Mortgage Research [email protected] (704) 383-4758

John McElravey, CFA, Director Head of Consumer ABS Research [email protected] (704) 715-7615

Chris van Heerden, CFA, Director CMBS and Real Estate Research [email protected] (704) 715-8321

Lad Duncan, Vice President CMBS and Real Estate Research [email protected] (704) 715-7423

David Preston, CFA, Vice President CDO and Commercial ABS Research [email protected] (704) 715-7383

Randy Ahlgren, Associate Residential Mortgage Research [email protected] (704) 715-8889

Zachary L. Bolster, Associate ABS and CDO Research [email protected] (704) 715-8382

Landon Frerich, Associate CMBS and Real Estate Research [email protected] (704) 715-8376

Bee Sim Koh, Associate Residential Mortgage Research [email protected] (704) 715-0536

Credit Research

Lee D. Brading, CFA, Managing Director Head of Credit Research [email protected] (704) 383-6491 HY Homebuilding, Building Products, Industrials

Gail Golightly, Managing Director Associate Director of High Grade Research [email protected] (704) 383-4836 HG Insurance

Matthew H. Burnell, Managing Director HG U.S. Financial Institutions [email protected] (704) 374-7148

James P. Dunn, Jr., CFA, Managing Director HG Basic Industries, Building Products, Diversified Manufacturing, Aerospace & Defense, Railroads [email protected] (704) 715-8377

Dennis M. Farrell, Jr., Managing Director HY Gaming, Lodging and Leisure [email protected] (704) 383-5037

Frank D. Henson, Jr., Managing Director HG Retail, Food & Beverage [email protected] (704) 715-8466

Bryan C. Hunt, CFA, Managing Director HY Food & Beverage, Food Retailing, Restaurants [email protected] (704) 383-0728

Grant Jordan, Managing Director HY Consumer Products, Retail, Technology [email protected] (704) 715-7022

S. Ross Payne, CFA, Managing Director HG Energy, Pipelines [email protected] (704) 383-3619

Thierry Perrein, Managing Director HG Real Estate Investment Trusts [email protected] (704) 715-8455

Nicole Black, Director HG Telecommunications, Media, Technology [email protected] (704) 715-7382

Duncan Brown, Director HY Healthcare [email protected] (704) 715-8332

Bishop Cheen, Director HY Media/Entertainment/Telecom [email protected] (704) 383-0473

Dan Forth, Director HG Credit Index Specialist [email protected] (704) 383-4097

Robert Hauff, Director HG Managed Care, Life Insurance [email protected] (704) 374-4176

Kamal Patel, Director HG Utility & Power [email protected] (704) 715-8195

James Spicer, Director HY Energy [email protected] (704) 715-8389

Kelly Burton, Vice President HY Homebuilding, Building Products, Industrials [email protected] (704) 383-5599

Donovan Chaney, Vice President HY Aerospace & Defense, Paper, Packaging & Forest Products [email protected] (704) 383-4030

Jason Jones, Vice President HG Healthcare Real Estate Investment Trusts [email protected] (704) 715-7932

James Strecker, CFA, Vice President HG U.S. Specialty Finance [email protected] (704) 715-0592

Erin K. Avery, CIMA, Associate HG Telecommunications, Media, Technology [email protected] (704) 715-0590

Winifred Cisar, Associate HY Healthcare [email protected] (704) 383-1967

Mike Ciulis, Associate HY Consumer Products, Retail, Technology [email protected] (704) 715-8489

David Deterding, Associate HY Energy [email protected] (704) 715-8418

Erica Gates, Associate HG Retail, Food & Beverage [email protected] (704) 374-7026

Davis Hebert, CFA, Associate HY Media/Entertainment/Telecom [email protected] (704) 715-0594

Jerod Lenderman, CFA, Associate HG Energy, Pipelines [email protected] (704) 715-1147

Kevin McClure, CPA, Associate HY Food & Beverage, Food Retailing, Restaurants [email protected] (704) 715-7887

Alex Schneider, CFA, Associate HY Gaming, Lodging and Leisure [email protected] (704) 383-6384

Jeff Stewart, Associate HG Basic Industries, Building Products, Diversified Manufacturing, Aerospace & Defense, Railroads [email protected] (704) 715-4130

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