structured finance

June 11, 1999

www.fitchibca.com

Structured Finance

Asset-Backed

Special ReportA Map to Rating Auto Loan-Backed Securitizations

AnalystsChris Mrazek212 [email protected]

Joseph Astorina212 [email protected]

James R. Grady212 [email protected]

Coley M. Lynch212 [email protected]

■ SummarySince the inception of the asset-backed securities (ABS) market, autoloan securitization has been a vital part of total ABS volume. Whileauto ABS has constituted a smaller portion of the total market in recentyears, these securities still contribute significantly to overall issuanceand are expected to remain a key component of the market in the yearsto come. Strong vehicle sales, attractive funding rates, and investordemand for short-term, highly rated liquid securities, characterized bysteady performance, prudent portfolio growth and investment-gradeservicers, will continue to drive issuance.

This report outlines Fitch IBCA’s approach to evaluating securitizationsbacked by retail auto loans, concentrating on prime quality loans. Itcovers all aspects of Fitch IBCA’s rating criteria, including collateralevaluation, credit analysis, structural considerations, and legal issues, aswell as discussions concerning originations, underwriting, and servicing.

■ Market OutlookAuto-backed issuance in 1999 is expected to exceed last year’s volumedue to strong new vehicle sales in 1998 and the first-quarter of 1999,as well as improving ABS market conditions. Fueled by a healthyeconomy and low interest rates, sales of new vehicles and light truckstopped 15.5 million units in 1998 and posted double digit growth in thefirst quarter of 1999. In step with robust sales, first quarter 1999 autoABS issuance outpaced 1998’s first-quarter by over 25%. Currentprojections estimate 15%–20% growth over last year’s volume. Primeretail loans, which supported more than 75% of total auto issuance in1998, are expected to back the majority of 1999 deals. The expansionof the auto finance market will continue to propel securitizationvolume, although the widespread consumer acceptance of leasing and“balloon loans” may encroach upon the supply of retail loans forsecuritization.

Retail auto sales remain dominated by the Big Three — Ford Motor Co.,General Motors Corp., and Chrysler Corp. (now DaimlerChrylser), whichconsistently garner more than 70% of market share. While the retailauto securitization market had appeared to become less reliant onissuance from the Big Three than in the past, the U.S. captives’ shareof auto issuance rebounded in 1998 and is on a similar course in 1999.However, many banks, independent finance companies, and foreignmanufacturers’ captive finance subsidiaries, particularly the Japanese,continue to access the ABS market, seeking the benefits of securitization,including diversification and lower cost of funds.

Fitch IBCA-Rated Prime Issuers

• Banc One Auto Grantor Trust• Capital Auto Receivables Asset Trust• Chase Manhattan Auto Grantor Trust• Chase Manhattan Auto Owner Trust• Chevy Chase Auto Receivables Trust• First Bank Auto Receivables Trust• Ford Credit Auto Owner Trust• GMAC Grantor Trust• Honda Auto Receivables Trust• Key Auto Finance Trust• Norwest Auto Trust• Premier Auto Trust

A Map to Rating Auto Loan-Backed Securitizations

2

Structured Finance

■ 1998 In ReviewPublic Auto ABS experienced modest growth in1998, falling short of expectations due to severalfactors, including widening spreads, industryconsolidation, the partial collapse of the subprimemarket, and issuers turning to alternative fundingsources. Poor market conditions late last yearcurtailed overall ABS issuance in the fourth quarter,and many auto lenders relied on asset-backedcommercial paper conduits and warehouse lines tofund growth. Certain highly rated entities elected tofinance loans on balance sheet during the disruption.Additionally, General Motors Acceptance Corp.(GMAC) was absent much of the year due to nowresolved labor strike and production issues.

Consolidation affected the industry as well asissuance in 1998. In addition to the wave of bankmergers and acquisitions, 1998 saw consolidation atthe manufacturer level. Chrysler Corp. merged withDaimler-Benz to form DaimlerChrysler, Ford MotorCo. acquired Volvo AB’s passenger car operations,and Nissan Motor Corp. was solicited by a fewpotential buyers, with Renault S.A. eventually takinga large equity position in the company.

Securitizations backed by auto loans to individualswith imperfect or incomplete credit histories(subprime), which surged in 1996 and 1997, nearlyceased in 1998, except for those wrapped by bondinsurers. Several upstarts succumbed to theconsequences of aggressive accounting andunderwriting activities, undercapitalization, weakservicing, and ineffective disposition efforts. Manywell publicized bankruptcies caused speculationabout the industry as a whole and severely trimmedissuance. As a result, the majority of public subprimeauto transactions in 1998 were insured. Thisphenomenon will likely continue, as many specialtyfinance companies lack the requisite capitalization,loss history, loss stability, and investor appetite tocomplete an economically efficient securitization onan uninsured basis.

■ Performance TrendsCompetition, increased used vehicle financing, longerfinancing terms, softer used car market, and risingconsumer bankruptcies led to lower recovery valuesand contributed to higher losses on auto pools in 1995and 1996. Issuers reacted, revisiting underwritingguidelines and servicing efficiencies in an effort tostabilize performance and ensure the credit strengthof future originations. The results of these measures

0

50,000

100,000

150,000

200,000

250,000

1994 1995 1996 1997 1998 1Q99

($ Mil.)

Auto ABS Other ABS

Auto ABS vs. Total ABS Issuance(Public)

Source: Asset Backed Alert.

0

5,000

10,000

15,000

20,000

25,000

30,000

35,000

40,000

1994 1995 1996 1997 1998 1Q99

($ Mil.)

Prime Auto Other Auto

Prime Auto ABS vs. Total Auto Issuance(Public)


0

5,000

10,000

15,000

20,000

25,000

30,000

35,000

40,000

1994 1995 1996 1997 1998 1Q99

($ Mil.)

Non-Big Three Big Three

Big Three Auto ABS vs. Total AutoIssuance


(Public)


3

Structured Finance

are now being realized, as losses on neweroriginations are showing signs of improvement.

Other trends that should contribute to betterperformance are: the rise in subvented lendingfrom the captives, as these loans are generallyextended to higher credit quality obligors; thedecrease of “C” and “D” quality loans in bank andcaptive portfolios and, if not a decrease in used carfinancings, a focus on one- to three-year old higherend vehicles with greater recovery value. Becauseof these patterns, Fitch IBCA expects loansoriginated in 1998 and 1999 to outperform those ofearlier years.

The graph below represents weighted averagecomposite static loss curves for auto deals issuedand rated by Fitch IBCA in 1995–1998. Asindicated earlier, losses were most severe in 1995and 1996 as a result of increased competition andlooser underwriting practices. As issuers reacted,lower losses were seen in 1997 and improvedfurther in 1998.

■ Collateral Analysis

Loan CharacteristicsThe vast majority of loans in auto securitizationsoriginate with an application sent to the financecompany by a dealer, although some securitizationscontain loans directly originated by the issuer. Directoriginations occur mostly in securitizations by bankissuers, in which customers fill out a loan application ata local branch. Fitch IBCA considers many variableswhen analyzing the collateral behind an auto loansecuritization, including vehicle age, downpayment,advance rate, depreciation, term, pricing, andgeographic diversification. In addition, Fitch IBCAexamines credit scores and tier classifications to gaugeperformance projections from pool to pool.

New vs. Used VehiclesThe market for used vehicles has grown rapidly overthe past couple of years and should continue toaccount for a significant percentage of the overallretail finance market. Reasons for this include: newvehicle prices are rising faster than used vehicleprices, making used vehicles more attractive toconsumers; less of a stigma is attached to purchasinga used car, since these vehicles are now more reliable

0

20

40

60

80

100

1997 1998 Jan-98 Jan-99

(%)

Big Three Other

U.S. Vehicle Sales1998 vs. 1997 Market Share

Source: Ward's Auto Info Bank.

0.00

0.25

0.50

0.75

1.00

1.25

1.50

1.75

2.00

2.25

2.50

2.75

3.00

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30

(%)

1995 1996 1997 1998

Composite Cumulative Net Losses for Securitized Pools1995–1998


4

Structured Finance

and last longer; and an abundant supply of off-leasevehicles. Also, the new vehicle sales market hasbecome extremely competitive, and the profit marginin this market is slim, compared with that of the usedvehicle market.

Several years ago, when Fitch IBCA observed anincrease in the number of used vehicles insecuritization pools, the general consensus was thatused vehicle loans performed similarly to newvehicle loans. This was based on the theory that,while used vehicle loans had a higher frequency ofchargeoffs than new vehicle loans, loss severity waslower due to the depreciation that the vehicle hadalready experienced.

However, recent experience demonstrates that, allelse being equal, used vehicle loans will experiencehigher delinquencies and losses than new vehicleloans. Interest rates on used loans generally reflectthe higher risk but provide little benefit under highloss scenarios. Fitch IBCA has also witnessed a movetoward one- to three-year-old vehicles and loweradvance rates on these loans. When examining asecuritization pool, Fitch IBCA looks closely at the newversus used mix and how it has changed over time. Thisway, the relative impact of used vehicle loans on anissuer’s prior pools can be measured. Fitch IBCAprefers to examine static pool loss data that distinguishbetween new and used for greatest accuracy.

DownpaymentFitch IBCA considers the downpayment amount onthe vehicle, as well as the total amount of the loan asa percentage of the wholesale cost of the vehicle.

Typically, as the downpayment increases, defaultsshould decrease due to the reluctance of the borrowerto forfeit equity in the vehicle. However, Fitch IBCAhas seen evidence supporting and refuting theperceived “equity link” in the vehicle, although in theprime sector, the connection seems more establishedthan in subprime. The bottom line seems to be themore equity the better, as loss severity will be lowerin the event of repossession.

Advance RateFitch IBCA analyzes the advance rate, defined as theloan balance as a percentage of the manufacturer’ssuggested retail price, in various ways. The advancerate may exceed 100% due to soft and hard add-onitems. Hard add-ons consist of actual items on thevehicle, such as a compact disc player or sunroof.Soft add-ons are items such as loss accident, andhealth insurance and extended warranty, which arerebatable in the event of default.

First, Fitch IBCA will consider the appropriateness ofthe lender’s underwriting and advance rate guidelines.Generally, advance rates are less important in theanalysis of prime borrowers than with subprimeborrowers, given the relatively lower probability ofdefault and repossession. Nevertheless, guidelinesshould have specified maximum advance rates thatmitigate the loss in the event of repossession.

Second, Fitch IBCA will examine the overalladvance rate on the pool versus that of prior pools. Ifan issuer had an overall advance rate on a priorsecuritization of 110% and the pool being securitizedhas an advance rate of 115%, for the same frequency

0

2,000

4,000

6,000

8,000

10,000

12,000

14,000

16,000

18,000

20,000

0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30 32 34 36 38 40 42 44 46 48 50 52 54 56 58 60

($)Estimated Depreciation Value 36 Months 48 Months 60 Months

Oustanding Balance of Loan*

*$18,000 loan. Assumes a 10% annual percentage rate.


5

Structured Finance

of repossession, losses would be expected to rise as aresult of the increased loss severity. Alternatively,even two pools with similar overall advance ratesmay demonstrate different losses because of differentadvance rate distributions. For example, if two poolshad overall advance rates of 110% each, but one poolhad a greater percentage of loans with very highadvance rates, adverse selection could result in adisproportionate number of chargeoffs among highadvance rate loans, which could lead to different lossexpectations for otherwise identical pools.

DepreciationRecoveries and ultimate losses may vary due todifferences in depreciation. With respect to the BigThree, Chase, Honda, and KeyCorp, these lenders’portfolios exhibit excellent make and modeldiversification and, therefore, stable depreciation ratesand subsequent recoveries. However, some independentfinance companies may not have the same suchdiversification as the captives and large nationalbanks. Portfolios with insufficient make and modeldiversification are exposed to risks such as vehiclerecalls or other quality-related problems that may causea particular manufacturer’s vehicle to rapidly depreciate.

Loan Term DistributionMost securitizations will consider a loan eligible forsecuritization only if its original term is 60 months orless. Loan terms of up to 72 months are occasionallyallowed but typically will be limited to a smallpercentage of the total pool, as losses tend to rise asthe loan term increases. This may reflect creditunderwriting, which relies on payment-to-incomeratios. Borrowers with low income will qualify onlyfor loans with low payments, which is typicallyachieved by lengthening the contract term. Anotherrisk of extended term loans is that principal willamortize more slowly, thus increasing loss severity inthe event of borrower default. The chart at the top ofpage 4 highlights the depreciation curve for astandard midsize vehicle, combined with theamortization schedule of a 36-, 48-, and 60-monthcontract. The car is assumed to sell for $18,000, andthe loan amount is also assumed to be $18,000. Asillustrated early on in the deal, the equity gap isconsiderably larger and lasts longer as the loan termincreases. In addition, when analyzing two pools ofloans with similar original loan terms, the distribution ofsuch terms should be considered, as there tends to be adisproportionate number of chargeoffs among extendedterm loans.

Annual Percentage RateFitch IBCA considers the total annual percentage rate(APR) of the pool, as well as the distribution ofAPRs, in its analysis. In general, borrowers with a

higher risk profile are assessed a higher interest rateas part of a lender’s tiered pricing strategy. However,one pool is not necessarily riskier than another if theoverall pool APR is higher. The interest charged thecustomer is also a function of the marketenvironment. Therefore, two otherwise identicalpools originated by the same issuer may havedifferent APRs as a result of the interest rateenvironment at the time of origination. It is alsoimportant to consider the distribution of APRs on theloans. For example, loans with very low APRs maybe subvented, or incentive, loans. Incentive loanscarry interest rates at a below-market rate due tofinancial support provided by either the vehiclemanufacturer or the captive finance company. Althoughthese loans have been extended to more creditworthyborrowers, they may decrease the availability of excessspread over time. Typically, a securitization containing asignificant concentration of incentive loans will includea yield supplement account or similar feature to ensurefull and timely noteholder payments. Lastly, it isimportant to examine the percentage of loans withhigh coupons, as these loans could indicate subprimeor nonprime customers that tend to charge off at amuch higher rate than the overall pool, therebydepleting excess spread.

Geographic DiversificationA pool of loan receivables should exhibit geographicdiversification to minimize its exposure to regionaleconomic downturns. The Big Three and Chaseportfolios are good examples of well diversifiedportfolios, although most prime issuers have anational focus. With the increased securitizationactivity of regional banks and independent financecompanies, Fitch IBCA has seen more geographicconcentration in these portfolios and closelyexamines the measures each lender takes to minimizeportfolio exposure to local economic events. FitchIBCA focuses on available management reports todetermine how a lender’s various geographic regionsperform. To date, Fitch IBCA has not seen significantdisparity in the loss and delinquency figures byregion for any given lender.

Most lenders are aware of their portfolio’s vulnerabilityto regional downturns and have customized creditscorecards to compensate for this risk. Caution shouldstill be used since state concentrations can affect cashflows from a securitized pool of auto loans,particularly in states with onerous repossessionrequirements. For example, Fitch IBCA has notedseveral instances where credit enhancement drawswere necessary due, in part, to difficulty in receivingvehicle liquidation proceeds with respect to vehiclesin Arkansas and Louisiana. Complying with therelevant laws in these states results in full balance


6

Structured Finance

chargeoffs where principal is due for the full loanbalance, but recoveries have not yet been received.Consequently, full-balance chargeoffs usually lead toliquidity strains and credit enhancement draws iflosses escalate.

■ Operational Review

UnderwritingFitch IBCA’s underwriting analysis focuses onquality and consistency. Fitch IBCA strives to ensurethat credit characteristics of the receivables thatproduced the base case loss estimate (see CreditAnalysis, page 8) are similar to those in the poolbeing securitized. The structure of the financecontract is also reviewed. Ultimate loss is a functionof frequency of default and severity of loss. Thecredit characteristics of the borrower largely dictatethe frequency of default. Advance rates allude to theseverity of loss. Hence, even if borrowers aredefaulting with the same frequency, losses can risedue to increased loss severity associated with higheradvance rates.

The majority of originators use credit scorecards toassist in the underwriting process. Credit scoring is amethod by which a large sample of defaulted loans isanalyzed to determine which variables arestatistically significant predictors of default. Scoringallows for the efficient and accurate credit assessmentof numerous applicants. The information used in thescorecards can be gathered from either the borrower’scredit report or the loan application. The variablesand weightings are used to determine a credit scorefor each applicant. This score is typically combinedwith the judgment of an experienced credit analyst,who makes the final decision. Generally, thoseindividuals scoring above a predetermined cutoffscore are recommended for acceptance, and thosescoring below recommended for denial. Lenders mayalso use multiple scorecards to analyze performanceamong different geographic regions or to compare theperformance of first-time car buyers with repeatbuyers.

Many lenders rely solely on information derived fromthe credit bureau report, as this information tends tobe more accurate and reliable than application data.In addition, information such as loan structure andadvance rates may not be as important in the analysisof the prime borrower as for the subprime borrower.The focus of the underwriting process for the primeborrower is on credit, which is different than underwritingfor subprime borrowers, where the collateral informationis critical given the higher likelihood of repossession.

Fitch IBCA will analyze the variables constitutingeach lender’s scorecard and consider how and whythese variables have changed over time. Fitch IBCAalso takes into account how often scorecards arevalidated to ensure that the cards maintain predictivevalidity. Furthermore, Fitch IBCA will examine howoften the credit score-dictated decision is overriddenand the process to evaluate overrides. Overrides canoccur in two ways — individuals who score belowthe cutoff score but are accepted and those who scoreabove the cutoff but are rejected. The reasons for theoverrides should be well documented, and theperformance of the overrides should be monitoredover time. Performance data on overrides should thenbe used to refine acceptance criteria.

Recently, issuers have been able to provide FitchIBCA with static pool loss data segmented by creditscore. Providing the scorecards are validated on aroutine basis, Fitch IBCA has found such data to bean extremely useful tool for estimating future poolperformance on a relative and absolute basis,although care must be taken to account for andunderstand the potential impact of credit scorechanges on future performance. With this type ofinformation, Fitch IBCA can adjust credit enhancementlevels to reflect the credit score distribution of thepool being securitized.

Seller/Servicer RiskIn prime auto transactions, the seller and servicer arealmost always one in the same, and the financialstrength of these entities always plays a pivotal rolein every structured finance transaction. The servicingfunction is one of the most critical aspects of loanperformance. Fitch IBCA has witnessed several caseswhere pools with nearly identical underwritingcriteria produce different loss numbers due toservicing capabilities. Moreover, a disruption ortransfer in servicing, no matter the length, will impairperformance. Consequently, careful attention is paid to aservicer’s financial strength and ability to accommodategrowth, collection, and repossession procedures, aswell as chargeoff policies. In the case of primelenders, risk of a disruption is partially offset sincethe majority maintain strong investment-grade ratingsby Fitch IBCA.

In cases where the seller/servicer is not rated by FitchIBCA, audited financials are reviewed to understanda company’s funding alternatives, existing corporatedebt structure, warehouse and bank facilities, and theunderlying motivation for securitization to assess atransaction’s viability. Full due diligence is thenperformed by a team of Fitch IBCA analysts from theStructured Finance and Financial Institutions groupsbefore a rating is assigned to a securitization.


7

Structured Finance

CollectionsThe collections process should be flexible enough toallow the borrower sufficient time to correctwhatever problem led to delinquency yet mustprovide that repossession commences quickly whennonpayment becomes inevitable. Most collectiondepartments are organized in one of two ways —stage of delinquency or cradle-to-grave. Departmentsorganized by stage of delinquency typically havejunior collectors on early stage delinquencies andsenior collectors for more serious late-stagedelinquents. These senior collectors are the lastopportunity the borrower has to work out the problembefore repossession. Departments organized with acradle-to-grave philosophy will have one collectorwork an account from its earliest stage of delinquencyuntil assignment for repossession. The thought behindsuch a structure is that the collectors will develop arapport with the borrower, become familiar with hisor her individual circumstances, and, thus, be morelikely to develop a cure for the delinquency. Whilethis argument may have some merits, it has beenFitch IBCA’s experience that more seriouslydelinquent accounts require the skills of experienced,seasoned collectors to bring the account current.

As prime customers have more options and meansavailable to solve their delinquency, collection effortsneed not commence on the first day of delinquency,as is typically the case with subprime borrowers. Arecent study by one bank showed that nearly 50% ofaccounts one day delinquent cured themselves by the20th day. Consequently, the bank found that theefficiency of its collectors was maximized by notcommencing any collections activity until accountswere 22 days past due. Generally, most financecompanies dealing with high-quality borrowers begincollections activity between 15–25 days past due.

ExtensionsLoan extensions or deferrals can be a valid method ofcuring delinquencies for borrowers who havesuffered temporary unemployment or some otherunexpected financial hardship. Extensions allow theloan to become current by adding another month tothe remaining term. To qualify, borrowers must nothave been delinquent for the past six months and aretypically limited to one extension for each 12 months

of an original contract term. Thus, a 48-month contractcould receive no more than four one-month extensionsover its life. Fitch IBCA is aware of the pitfallsassociated with these tactics as short-term fixes fordelinquencies and scrutinizes the extension policiesof each lender; however, prime lenders tend toemploy this strategy infrequently.

Repossession and DispositionThe chart above depicts a repossession timeline for arepresentative prime lender. Fitch IBCA pays carefulattention to each point on this line, as disruptions caninfluence recoveries on repossessed collateral andinterrupt payments to securityholders. First, FitchIBCA examines when the vehicle is assigned forrepossession and considers how much collectioneffort the account has received prior to assignmentfor repossession and if the borrower has had ampleopportunity to bring the account current.Repossession should only be considered a last resort.

Next, it is important that the vehicle be located andrepossessed as soon as possible. Provided that theborrower is not hiding the vehicle or has not“skipped,” a fully licensed and bonded repossessionagent should be able to locate and repossess thevehicle in a matter of days. Finally, Fitch IBCAfocuses on the time it takes from repossession toultimate sale. It is important that vehicles be sold asquickly as possible to maximize the recovery on thevehicle and lower carrying costs. Cars left todepreciate on auction lots will have significantlylower recovery values, adversely affect loss severity,and strain liquidity in the deal.

Fitch IBCA prefers that repossessed vehicles bedisposed of through wholesale auctions with acompany representative on site. While the ultimaterecovery will be lower than if the vehicle were soldon a retail basis, Fitch IBCA has noticed that thewholesale disposition of repossessed vehicles tendsto be a more efficient and predictable means ofreceiving recoveries. Retail disposition, wherebyvehicles are sold on used car lots, can result inlengthy delays in the receipt of recoveries. Inaddition, any benefit of retail channels may be offsetby increased depreciation during the potentiallyextended sales period. Securitization performance

Repossession Timeline

Collections Efforts/Assignment Repossession

NOI

Expires

Condition

Report;

Order

Repo Title Receive Title

Disposition

At

Auction

60 Days 75 Days 95 Days 105 Days 1125 Days 130 Days0 10 20 30 40 50 60 70 80 90 100 110 120 130

NOI – Notice of intent to repossess.


8

Structured Finance

can suffer in the event of substantial delays in thereceipt of vehicle liquidation proceeds.

Chargeoff and RecoveryThe performance of auto securitizations dependsheavily on an efficient repossession and recovery process.The documentation supporting each securitization trustspecifies when a loan is deemed defaulted and thefull principal balance then due to the trust. Thistypically occurs 120 days after initial delinquency.Recovery proceeds from vehicle disposition usuallyflow through to the trust within the next month. Theissuer’s internal policies and procedures must beconsistent with the trust documentation to minimizethe effect of full balance chargeoffs and preventdelays in payments to securityholders. Full balancechargeoffs occur when the full principal balance ofthe loan is due to the trust and the recovery amountassociated with the sale of the vehicle has not beenobtained. If the servicer is unable to complete therepossession process in the time required by the trustdocumentation, credit enhancement must make up theshortfalls. If full balance chargeoffs are a highpercentage of total defaults, excess servicing strainsand credit enhancement draws could pressure transactionliquidity and disrupt payments to bondholders.

Fitch IBCA stress scenarios anticipate and providefor this occurrence. As a general rule, Fitch IBCAwill assume delays in recoveries associated withcharged off loans. The assumed delays will vary byissuer but range between three and five months.

After the vehicle has been repossessed and sold, adeficiency judgment is obtained by the lender for the

amount it is still owed after the sale of the vehicle.Fitch IBCA will consider each lender’s historicalexperience with respect to pursuing deficiencyjudgments and incorporate these recoveries into thelender’s loss severity analysis.

■ Credit Analysis

Static Pool AnalysisThe essence of Fitch IBCA’s credit analysis lies ininterpreting static pool loss data. Static pool data areuseful in determining the magnitude and timing oflosses and provide one of the best indications of howthe underlying loans will perform under stress. Dataare either directly provided by the issuer or are culledfrom prior securitizations. While data from existingsecuritizations are useful, information provideddirectly by the issuer is often more detailed and,therefore, superior. In the past, issuers have been ableto provide Fitch IBCA with detailed static poolanalysis, capturing portfolio performance by new andused vehicles, loan term, credit score, and evenvehicle type. This analysis is critical in helping FitchIBCA understand the unique loss drivers associatedwith each issuer’s portfolio and helps provide themost accurate loss projection and credit enhancementlevels for each securitization.

Relying solely on historical static pool information togauge future losses would be sufficient if the pastwere a perfect predictor of the future. However, staticpools capture performance over a specific period and,thus, will have unique macroeconomic factorsinfluencing their outcome. Consequently, it isimportant to evaluate the economic conditions

0

2

4

6

8

10

12

14

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32

Premier AFG Honda

Weighted Average Cumulative Net Loss Curves

(%)

Months Since Origination


9

Structured Finance

present for the period captured with each static pool.Changes in underwriting guidelines also affect poolperformance, rendering it equally important tounderstand the changes made to underwritingguidelines over time and to adjust current lossexpectations as appropriate.

After considering all the factors detailed above, FitchIBCA will determine its base case loss expectation.For conservatism, Fitch IBCA’s base case estimatewill usually be derived from the static pools with thehighest loss figures rather than an arithmetic average.However, if significant improvement has occurred or apool appears to be an outlier, this will be considered inthe analytical process. To gauge loss volatility, FitchIBCA relies on many factors, including samplestandard deviation.

Loss SpeedThe graph on the bottom on page 8 captures staticpool information for three frequent securitizers,American Honda Finance Corp. (AHFC), ChryslerFinancial Corp., and AutoFinance Group (AFG).AFG was acquired by KeyCorp in September 1995and renamed Automotive Specialty Finance. Thecompany remains the specialty finance arm of KeyBank USA, N.A. The static pool informationpresented is a weighted average of cumulative netlosses for all pools since the month that they weresecuritized. The information presented for the Hondaand Chrysler pools is typical for pools consisting ofhighly creditworthy borrowers. The AFG loansrepresent loans to individuals with prior creditproblems and are common for companies in thissector. As is evident, less creditworthy borrowers

tend to default earlier in the life of a loan and withgreater frequency.

The chart above contains a representative sample ofthe percentage of cumulative net losses experiencedsince securitization for a prime issuer. Frequentsecuritizers, such as Chrysler and Ford, come tomarket several times a year. Accordingly, these poolstypically have limited seasoning. As is illustrated, theloss curve is very quiet in the early months. However,occasionally, issuers will look to securitize pools thatare well seasoned. Credit enhancement requirementsfor such pools will typically be lower than for anewly originated pool, as a portion of the ultimatelosses on the pool has already occurred. The amountof credit given for such seasoning is a direct functionof the originator’s historical static pool loss historyand loss volatility, as well as the amount of seasoningon the pool. Moreover, an examination of loss speedenables Fitch IBCA to project ultimate losses onpools that have not yet reached maturity. However,due to variances produced by different underwritingand servicing standards, Fitch IBCA relies on astatistical evaluation of each lender’s unique lossdistribution for cash flow modeling purposes.

Stress MultiplesAfter considering the aforementioned items, FitchIBCA determines its base case level of cumulativenet losses over the life of a representative pool ofloans. The base case is generally associated with a ‘B’rating category. Stresses outside the standard multiplesare lender-specific and are a function of servicingability, historical loss volatility, availability and amountof static loss data, portfolio growth, and collateral

0

10

20

30

40

50

60

70

80

90

100

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

Lifetime Loss Distribution for Prime Auto Loan Pool

(%)

Months


10

Structured Finance

composition. For prime auto loans, Fitch IBCA has used‘AAA’ stress multiples ranging from 4.5 times (x) to6.0x the base case loss estimate. The ‘A’ stress multipleshave ranged between 2.5x –3.5x the base case.

As demand for higher yielding securities grows,many investors are favoring subordinated tranchesfrom stable, higher rated issuers over riskiernonprime and subprime transactions from non-investment-grade entities. As such, Fitch IBCA hasbeen asked to rate down to ‘BBB’ and ‘BB’ levels onprime securitizations with greater frequency. Whilethe credit analysis for these securities is similar tohigher rated classes, the dependency on excess spreadfor credit enhancement is far greater. In fact, it is notuncommon for a ‘BB’ rated class to be supported solelyby excess spread. Loss multiples for these ratingcategories range from 2.0x–2.5x base case cumulativenet losses for ‘BBB’ and 1.0x–2.0x for ‘BB’.

■ Structural AnalysisFitch IBCA’s analysis of auto securitizations focusesprimarily on the credit characteristics of the underlyingreceivables. Fitch IBCA has analyzed a multitude ofstructures and is generally able to approve most structureswhere the multiple of losses being covered is consistentwith the desired rating. As the structuring alternativesavailable to issuers continue to grow, Fitch IBCA focusesits analysis on the credit of the underlying receivables andallows the issuer to determine the most efficient structure.

However, once a structure has been selected, Fitch IBCAcreates a custom cash flow model for each transaction toensure that under deteriorating conditions the asset cashstreams and integrity of the structure are sufficient topay investors in full.

Sources of Credit EnhancementConsiderable discussion has been devoted to how FitchIBCA assesses loan quality and uses static pool loss datato derive its base case loss estimate and loss coveragerequirements for each rating category. Next is theevaluation of the sources of credit enhancement.

The primary forms of credit enhancement used insecuritizations with internal credit enhancement areexcess spread, reserve accounts, subordination, andovercollateralization. Transactions that use guaranteesfrom the monoline bond insurers are not considered, sincethese transactions derive their rating directly from therating of the monoline bond insurers that guarantee timelypayment of principal and interest on the bonds.

As might be expected, not all forms of credit enhancementoffer investors the same level of protection. Furthermore,enhancement levels often vary among securitizations by thesame issuer. For example, an issuer securitizing a collateralpool with a greater percentage of used vehicles than priorsecuritizations is likely to have increased creditenhancement requirements, as used vehicle loans typicallyhave higher and more volatile losses than new vehicleloans. Similarly, a higher percentage of incentive loans willlikely decrease enhancement needs.

The following section outlines how Fitch IBCA analyzesthe major forms of internal credit enhancement used inauto securitizations.

Excess SpreadThe amount of credit given for excess spread as creditenhancement in Fitch IBCA’s stress scenarios isinfluenced by the following:

Excess Spread as Credit Enhancement

Collateral Balance 250,000,000 Weighted Average Collateral APR 11.50%

Weighted Average Original Term 54 Months Servicing Fee 1.00%

Weighted Average Remaining Term 54 Months Weighted Average Bond Coupon 6.50%

Base Case Cumulative Net Losses 2.25%

Recovery Rate 50.00% Prepayment Assumption (ABS) 1.00%

Recovery Delay 3 Months

Model Run Description Required LossCoverage (%)

Hard Credit Enhancement (%)

AvailableExcess (%)

CollateralAverage Life

(Years)Base Case Losses/Delinquent Interest/

WAC Compression/No Prepayments N.A. N.A. 7.91 2.44

Base Case Losses/Delinquent Interest/

WAC Compression/Prepayments 2.25 0.00 6.39 1.98

'A' – 3 Times Base Case Losses/

Delinquent Interest/WAC Compression/Prepayments 6.75 2.25 5.34 1.89

'AAA' – 5 Times Base Case Losses/

Delinquent Interest/WAC Compression/Prepayments 11.25 8.50 3.69 1.78

APR – Annual percentage rate. ABS – Absolute prepayment speed. WAC – Weighted average coupon. N.A. – Not applicable.


11

Structured Finance

Delinquent Interest: The impact of delinquentborrowers on the stated APR is assessed for everyissuer. As a servicing report is essentially a detailedstatic pool analysis, Fitch IBCA examines servicerreports to capture the actual APR (calculated on thebasis of interest received) versus the stated APR. Theresults of this analysis are incorporated into FitchIBCA’s cash flow models. As would be expected,delinquencies are a precursor to losses and, therefore,are similarly distributed. Delinquencies tend to behighest in the first year or two of a pool’s life anddiminish by the third year. Fitch IBCA assumes0.50%–0.75% delinquent interest for year one andthen 0.25%–0.50% in subsequent years. Thesestresses are generally adjusted by rating category.

While servicer advances help alleviate this problem andprovide needed liquidity, Fitch IBCA generally does notgive credit for servicer advances. They are usually thefirst item to be paid out of the waterfall in subsequentcollection periods and, thus, provide no real creditprotection. In addition, most servicers are rated lowerthan the rating carried by the most senior bond.

Weighted Average Coupon Compression: A largepercentage of high interest rate loans along with awide distribution of rates can cause a pool’s interestcollections to decline over time due to involuntaryand voluntary prepayments. Analysis of thereceivables pool and servicing reports allows FitchIBCA to identify pools of loans that may be vulnerableto weighted average coupon (WAC) compression.Fitch IBCA has observed that pools with a largenumber of incentive loans exhibit WAC compression.Voluntary prepayments on these loans are low, as theincentive to prepay is minimal. In addition, borrowerswith high creditworthiness ordinarily qualify forthese loans, resulting in low involuntary prepaymentsas well. Therefore, over time, most total prepaymentson the pool will come from the higher interest rateloans, which will tend to move the portfolio’s overallWAC closer to that of the subvented loans, resulting inless available excess spread to cover losses.

Prepayments: Fitch IBCA will examine prepaymentexperience for issuers by collateral type, term, and rateto determine the likelihood of voluntary prepaymentand the potential for adverse selection. Once a speedhas been determined, it is incorporated into cash flowmodels and is generally held constant unless datasuggest otherwise. As noted above, high prepaymentswill reduce the average life of the securities, generateless excess spread, and potentially require higher levelsof hard credit enhancement. Fitch IBCA modelsprepayments using either the absolute prepaymentspeed (ABS) or the constant prepayment rate (CPR)assumption. ABS is the preferred method, since auto

collateral tends to exhibit increasing prepayments asloans season, a trend CPR does not capture.

Average Life Reduction: High stress multiplesdecrease the average life of the pool, reducing excessspread over the life of the transaction. Since voluntaryprepayments are held relatively constant, average lifeis primarily reduced through high defaults.

Captured Excess Spread: Excess spread is modeledon a “use it or lose it” basis. Fitch IBCA models willincorporate reserve fund and overcollateralization targets.However, after consideration of the items listed above,these targets are typically not as important as theinitial deposit. This is because, under stress scenarios,excess spread is usually exhausted.

The example on page 10 demonstrates how muchcredit enhancement would be needed for ‘AAA’ and‘A’ ratings and how much excess spread might beavailable to cover losses in a typical sequential-payauto loan securitization. General loan and bondinformation for the securitization with limitedseasoning is shown. Base case cumulative net lossesare assumed to be 2.25% and recoveries 50%, with athree-month delay to recovery. Voluntaryprepayments are held constant at 1.0% ABS. Toachieve ‘AAA’ and ‘A’ ratings, 11.25% and 6.75%loss coverage is needed, a portion of which could befunded from excess spread.

In the absence of prepayments and losses, availableexcess spread is 7.91% over the life of the collateral.However, in a stress scenario, excess spread wouldbe significantly reduced by delinquent interest, WACcompression, prepayments, and losses. As shown,available excess spread drops as low as 3.69% as stressis applied and the average life of the pool shrinks.The decrease in the average life is a directconsequence of the increase in the default rate.

Reserve AccountMost auto securitizations use spread or reserveaccounts, which are typically funded with an initialdeposit and trap excess spread up to a requiredamount. Spread accounts are useful for meetingtransaction expenses and providing liquidity, whichmay be strained during periods of high losses. FitchIBCA’s main emphasis in sizing spread accounts ison the initial deposit, not the target amount, as theinitial deposit typically dictates the minimum level oflosses a securitization can withstand at closing whenthe rating is assigned. Under high loss scenarioswhere losses are front-loaded, excess spread isdepleted before the reserve account reaches its target.


12

Structured Finance

Generally, for each month the securitization performsat or better than the base case projection, ongoingloss coverage multiples improve. This partly reflectsthe fact that a substantial portion of portfolio losseswill occur in the first year. If the reserve accounttarget is reached, a greater amount of creditenhancement is available to cover expectedremaining losses, and the ongoing multiple of lossesthe transaction can withstand is significantly greaterthan it was at day one. A nondeclining reserve willfurther boost the available credit enhancement.

Fitch IBCA assigns its ratings based on the level ofloss protection available at day one and availableexcess spread trapped. Most reserve accounts aresized to reach their target in six to nine months underbase case loss expectations.

Subordination/OvercollateralizationSubordination and overcollateralization (OC) areconsidered together as they both represent anownership interest in the underlying receivables and,from a cash flow perspective, behave similarly. If aninvestor’s pro rata share of collections is insufficientto make scheduled payments, funds otherwisepayable to the seller or to junior bondholders are usedto pay senior bondholders.

Pure overcollateralization consists of an ownershipinterest in the receivables retained by the seller anddoes not have a coupon expense associated with it.Subordinate tranches typically have coupon expensesand, therefore, will result in less cash for seniorbonds than OC. Both will generally offer less credit

protection than a cash reserve account, since theydepend on available collections.

Whatever credit enhancement form is chosen,detailed cash flow modeling is essential to properlyevaluate each and to ensure that the appropriateprotection for the desired rating category is achieved.

Owner Trust vs. Grantor TrustThe two dominant structures in auto loan securitizationare grantor and owner trusts. Grantor trusts requireprincipal distributions on underlying securities to bemade on a pro rata basis. As such, in the absence oflosses, the senior and subordinate classes in a grantortrust will have the same average life. However, in anowner trust, cash flows can be allocated in anymanner stipulated by the deal documents. There arealso differences in the tax treatment of the two trusts,but these issues are not credit related. As long as anentity level tax does not exist on the trust, the amountof cash available to bondholders is unaffected.

Owner trusts allow for the creation of tranches withspecific payment characteristics and varying averagelives. Tranching is a useful method of enhancing theattractiveness of a trust’s securities to a widerinvestor audience. For example, in the typical grantortrust transaction, senior investors usually only havethe option of purchasing a bond with an average lifeof approximately 1.5–1.7 years and are limited to twotranches. However, senior investors in an owner trustcan usually chose among bonds with average lives ofbetween 0.25–4.00 years.

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

01 03 05 07 09 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39

(ABS)

1995-A 1995-B 1996-A 1996-B 1996-C 1997-A 1997-B

1998-A 1998-B 1998-C

Chase Manhattan Auto Securitization Prepayment Speeds*

*ABS speed is a three-month rolling average.

Months Since Origination


13

Structured Finance

Another feature of owner trusts is the use of excessspread as additional principal. Excess servicing canbe reallocated to pay down the note balance in eachperiod (full turbo) or until a specified level ofovercollateralization is achieved (partial turbo).Overcollateralization is created since the securitiesare being amortized faster than the collateral pool.When determining credit enhancement requirementsin owner trusts, Fitch IBCA focuses on the level ofovercollateralization available at the beginning of thetransaction, not the target overcollateralizationpercentage. Fitch IBCA considers this appropriate andconservative, since, under stress scenarios, theovercollateralization target is never reached, althoughcredit is assigned to what is achieved.

From a credit perspective, Fitch IBCA does notdifferentiate between the loss expectation of anowner trust versus that of a grantor trust. The losseson the transaction do not determine cash flowallocations to investors. Nevertheless, the structuralcharacteristics of an owner trust could lead to lowercredit enhancement requirements than a grantor trust.Consider an owner trust in which the subordinateclass is locked out of principal until the senior class ispaid in full. In this structure, available credit protectionwould increase over time. This structural protectionmechanism leads to lower credit enhancementrequirements than a typical grantor trust structure.

Owner trusts also have unique structural features thatmust be incorporated into the cash flow. Forexample, many owner trusts incorporate a moneymarket tranche that the issuer desires to be eligiblefor money market investors under Rule 2a-7 of theInvestment Company Act of 1940. Consequently, it isnecessary for this bond to have a legal final maturityof no more than 13 months. Issuers typically want themoney market tranche be sized as large as possible,since this bond will be priced off the lowest point ofthe yield curve, assuming the yield curve is upwardsloping. However, Fitch IBCA limits the size of themoney market tranche to the maximum that can berepaid by the legal final maturity under Rule 2a-7using a 0.5% ABS prepayment speed and no losses.

The chart on page 12 depicts prepayment speeds onChase’s auto securitizations. As is evident, there isconsiderable variability early in the life of eachtransaction. At no point are prepayments less than 0.5%ABS, a figure that Fitch IBCA considers representativefor sizing money market tranches. Fitch IBCA willexamine each issuer’s unique prepayment experience,and higher or lower prepayment figures may be usedto size money market tranches.

■ Legal IssuesAs with other ABS transactions, retail autosecuritizations are structured to isolate the auto loansfrom the bankruptcy or insolvency risks of the otherentities involved in the transaction (auto loan sellerand/or originator). This is typically accomplished bythe seller/originator transferring the auto loans (eitherdirectly or indirectly depending upon the chosenstructure and the type of entity making the transfer)by means of a “true sale” or series of “true sales” toone or more “bankruptcy-remote” entities, one ofwhich will ultimately issue the asset-backedsecurities to the investors. In cases where a FDIC-insured bank or another bankruptcy-remote entity istransferring the auto loans to a bankruptcy-remoteentity, such transfer may take the form of a firstpriority perfected security interest. Furthermore, ifthe bankruptcy-remote issuer is issuing debtsecurities, those debt securities should be secured bythe grant of a first priority perfected security interestfrom the bankruptcy-remote issuer to the indenturetrustee for the benefit of the debt holders.

For an entity to be considered bankruptcy-remote,Fitch IBCA generally requires that it be a so-calledspecial purpose entity (SPE). An SPE can take manyforms (corporations, limited liability companies, andtrusts, among others.). However, no matter what typeof organization the SPE is, the SPE should be formedand operated in ways designed to mitigate thelikelihood of both voluntary and involuntarybankruptcy. A properly structured SPE should haverestriction on its powers, its ability to incur debt andto pledge its assets and to merge or reorganize. Inaddition, the SPE should be bound by a series ofcovenants that are designed to maintain its“separateness” and thereby mitigate the potential thatthe SPE and its assets could be substantivelyconsolidated into its parent’s bankruptcy.

To ensure that a retail auto securitization isappropriately structured to isolate the pool of autoloans from the bankruptcy risk of other parties, FitchIBCA reviews the transaction documentation andlegal opinions. Legal opinions should address thenature of the various transfers in the transaction andprovide assurance that neither an SPE, nor its assetsand liabilities, would be consolidated with the assetsand liabilities of its parent, or of the other sellersand/or originators of the auto loans, in any suchparty’s bankruptcy. With respect to transfers from thesellers and/or originators of the auto loans to an SPE(together with all of the transfers in between), thelegal opinions should state that the auto loans beingtransferred will not be property of the transferor’sbankruptcy estate in the event of such party’sbankruptcy or be subject to the automatic stay in such


14

Structured Finance

bankruptcy. In addition, in many cases the legalopinions also should state that the pledge of the assetsfrom an intermediate SPE to the issuer and from theissuer to the indenture trustee for the benefit of debtholders creates a first priority perfected securityinterest in the auto loans and their proceeds.

In addition, auto loans have certain distinctivefeatures that require additional legal comfort beyondthe traditional issues associated with the structure ofABS transactions. Auto loans typically areconsidered chattel paper under the applicable state’sUCC. As chattel paper, both the sale of, and grant ofa security interest in, the auto loans are perfected bypossession of the original documents or filing ofUCC financing statements. Consequently, either theissuer or a custodian on behalf of the issuer or thedebt holders must possess the original documents or,more typically, UCC financing statements must befiled to perfect the various transfers. The legalopinions should address the perfection of suchtransfers (whether as a sale or the grant of a securityinterest) among the various parties.

Auto loans are also somewhat unique in that the saleor assignment of security interest in the automobilesis typically governed by certificate of title laws in theapplicable states. As a result, the sale of, andassignment of security interests in, automobiles arenoted on the title certificate for each automobile.Because of the expenses and difficulty of re-titlingautomobiles, Fitch IBCA generally does not requirethe certificate of titles to be amended to reflect thesubsequent assignments of the liens on theautomobiles to the various parties in the transaction.However, in cases where there are materialconcentrations of automobiles in particular states,Fitch IBCA generally requires local counsel opinionsto confirm that the issuer and the indenture trusteewill have a first priority perfected security interest inthe automobiles in those particular states.

Finally, Fitch IBCA also typically requires that thelegal opinions address the tax status of the issuer inthe transaction. Such opinions should state that theissuer would not be subject to federal tax or to stateor local taxes in all applicable jurisdictions.


15

Structured Finance


16

Structured Finance

Copyright © 1999 by Fitch IBCA, Inc., One State Street Plaza, NY, NY 10004Telephone: New York, 1-800-753-4824, (212) 908-0500, Fax (212) 480-4435; Chicago, IL, 1-800-483-4824, (312) 214-3434, Fax (312) 214-3110;London, 011 44 171 417 4222, Fax 011 44 171 417 4242; San Francisco, CA, 1-800-953-4824, (415) 732-5770, Fax (415) 732-5610John Forde, Publisher; Madeline O'Connell, Director, Subscriber Services; Nicholas T. Tresniowski, Senior Managing Editor; Diane Lupi, Managing Editor; Paula M. Sirard, ProductionManager; Jennifer Hickey, Andrew Simpson, Sandra Wagman, Igor Zaslavsky, Editors; Martin E. Guzman, Senior Publishing Specialist; Harvey Aronson, Publishing Specialist; Yvonne Y. Pak,Robert Rivadeneira, Publishing Assistants. Printed by American Direct Mail Co., Inc. NY, NY 10014. Reproduction in whole or in part prohibited except by permission.Fitch IBCA ratings are based on information obtained from issuers, other obligors, underwriters, their experts, and other sources Fitch IBCA believes to be reliable. Fitch IBCA does not audit orverify the truth or accuracy of such information. Ratings may be changed, suspended, or withdrawn as a result of changes in, or the unavailability of, information or for other reasons. Ratings arenot a recommendation to buy, sell, or hold any security. Ratings do not comment on the adequacy of market price, the suitability of any security for a particular investor, or the tax-exempt natureor taxability of payments made in respect to any security. Fitch IBCA receives fees from issuers, insurers, guarantors, other obligors, and underwriters for rating securities. Such fees generallyvary from $1,000 to $750,000 per issue. In certain cases, Fitch IBCA will rate all or a number of issues issued by a particular issuer, or insured or guaranteed by a particular insurer or guarantor, for asingle annual fee. Such fees are expected to vary from $10,000 to $1,500,000. The assignment, publication, or dissemination of a rating by Fitch IBCA shall not constitute a consent by Fitch IBCA to useits name as an expert in connection with any registration statement filed under the federal securities laws. Due to the relative efficiency of electronic publishing and distribution, Fitch IBCA Researchmay be available to electronic subscribers up to three days earlier than print subscribers.

structured finance

Documents

auto finance market

auto lenders

public auto abs

retail auto loans

structured finance auto

retail auto sales

key auto finance trust

auto grantor trustauto