Auto ABS: Car finance shifts from ownership to usage

Auto ABS landscape: European car drivers seem to be slowly but surely shifting from vehicle ownership to usage. That trend has some credit risk implications, explains Alex Garrod, Senior Vice President European ABS at DBRS Morningstar, the world’s fourth largest credit ratings agency.

How does today’s European Auto ABS landscape look from where you are sitting?

“DBRS Morningstar rates around 50% of the new Auto ABS European deals so we have a good overview of what is going on. From an activity point of view, I think many market observers expected Auto ABS activity to slow down due to COVID and the geopolitical issues we are facing, but that is not the case. Our forecast for 2022 is slightly up versus 2021.”

Were you surprised by that?

If you only look at the falling numbers of new vehicle registrations you might say that Auto ABS volumes should be down, but people are still using, buying and financing cars. There seems to be pent up demand for new vehicle financing. This might reflect slightly improved supply chains, and we see some of that demand potentially flowing through into 2022.

There is certainly more activity in used vehicle financing. And we are also seeing more originators of used car financing products coming to the market. Volume-wise we typically see around 40 transactions a year with an average portfolio size of around €700 mln. In recent years we have seen these falling slightly and this reflects the composition of the portfolios which include more used vehicle financing with lower initial advances.

Are there specific trends in terms of countries?

Historically there have always been trends which split the northern and southern European markets. The southern European market was characterised by people who bought a vehicle, held it for a long time and the financing products supported that. They were typically standard amortizing loan products based on standard monthly payments for a period of seven or eight years.

In the northern European market, we’ve seen continued growth in trade cycle management products. These are loans that look to shorten the vehicle usage cycle and incorporate a balloon payment component, meaning a larger payment at the end of a contract. We also observe leasing products where the customer is effectively renting the vehicle and at the end of the leasing contract returns the vehicle to the lessor.

Is that landscape changing?

Yes, it is. It appears the mentality in the southern European countries is moving more towards trade cycle management concepts. They are starting to transition from a vehicle ownership model to a vehicle usage model. France is a particularly interesting example at the moment and over the last two years we have seen a lot of auto lease transactions primarily focussed on new vehicle financing. In the past there was a cultural element which meant that certain markets did not embrace that financing concept. That seems to be slowly fading away in this low interest rate environment and making way for a subscription type approach that we are now all familiar with across many other products.

Are there credit risk implications to this shift?

There are. With the traditional loans the main credit risk was: “will the customer pay me back on time?” This new usage trend introduces the additional market value risk-related question: “at the end of the contract will the vehicle be worth enough to cover the outstanding balance on the contract?”.

What are the main usage models?

There are balloon loans, which rely on a large payment at the end of the contract that is ultimately payable by the borrower. And lease contracts which rely on the residual value of the vehicle and subsequent sales proceeds. The credit risks associated with balloon loans are payment shock for the borrower or the car dealer if there is a reliance on the dealer to settle the financed amount. In terms of leasing, the concept of residual value supports an expectation that the vehicle will be returned to the leasing company at maturity and there are different strategies to manage this depending on the financing product.

What type of strategies?

For operating lease transactions (which are prevalent in the Netherlands) we often see the leasing company able to resize the residual value exposure over the life of the contract, depending on how much the customer has used the vehicle. However, that residual value exposure under a leasing contract, and under an Auto ABS transaction, is effectively transferred to the investor. The investor is therefore not just taking the risk on whether the customer will pay their monthly instalments, they are also taking the risk on the value of the vehicle at contract maturity. That is a key factor in our rating analysis.

Do you as a credit analyst have to look at both those elements in order to evaluate the risk effectively?

We have recently observed a lot more residual value risk. Credit losses for Auto ABS transactions have been extremely low and continue to be low over a sustained period of time. So, the notion of “will they pay me an instalment or not” is becoming less significant. It has become more a question of how much the vehicle will be worth in three or four years’ time.

Are there therefore ESG considerations to be taken into account when assessing this future value of a vehicle?

One of the challenges we have is that we need data to be able determine impacts on future vehicle values. Originators don’t necessarily have this data to hand because they have not been originating loans or leases for a long enough period of time to see those contracts mature. And there is also an element of confidentiality surrounding that data. At DBRS Morningstar’s we have a direct relationship with one of Europe’s largest automotive data providers and they support us in answering some of these forward-looking questions that may not yet be supported by historical data.

Do you see ESG becoming a component in Auto ABS?

ESG obviously has three components and when we think about cars, we all immediately think only about electric vehicles. There are a lot of discussions in Auto ABS at the moment as to whether it is possible to classify transactions as green or not. There is a debate about what that could be based on: the underlying collateral supporting the loans or leases — so the vehicles (through the receivables). Or do you look at the use of proceeds concept? This looks at how those funds are used once following the issuance of notes.

Theoretically one could have a non-green pool of assets whereby the proceeds may be used by an originator to invest in the sustainable production of new vehicles, for example. It is complex. The European Commission’s Green Bond Standard, seems very much to be pointing securitisation towards adopting the use of proceeds concept to achieve alignment across other financial instruments.

Do you agree?

Regardless of the classification, the question I need to ask myself is: “is this a relevant consideration within our credit analysis?” And the answer is: “of course it is!” The value of a vehicle in three years’ time is relevant. It may not wholly depend of fuel type. It may be the age of a vehicle, the colour of the vehicle, the size of the vehicle and so on. But it is undeniable that the fuel type of a vehicle is an important consideration when looking at future residual value performance.

Can you get that data?

According to the Securitisation Framework, originators are required to submit loan-level details for their portfolios through the ESMA underlying exposures template and this is where I would expect to find relevant and potentially significant information from an ESG perspective, in order to understand vehicle characteristics.

However, there is very little relevant information in these submissions: we don’t have fuel type information, the only ESG-type variable we have in those templates is an Energy Performance Certificate value and these vary by country. There are around 9,000,000 vehicles reported in the European Data Warehouse at the moment across EU countries, and only around 15% of those vehicles have Energy Performance Certificates. I believe there is a lot of ESG data that is potentially available but is not offered to market participants which is a missed opportunity in my view.

Do you think originators may change in this respect?

I think it is a reasonable expectation that you have relevant market value data to support the relevant risks for an Auto ABS transaction. On a positive note, we are slowly seeing more originators supplying EPC data in these templates. I hope this is just a transition period and that issuers will see the benefit of providing a higher level of data transparency to evaluate residual value risk going forward.

Are there any more specific topics that you think are interesting within the Auto ABS space which are likely to come up during the Securitisation Event?

I think we could talk about ESG all day! However, there are other things which are likely to come up during the event which I am interested in, including significant risk transfer. We have seen a real increase over the last two years in the use of SRT-type transactions for Auto ABS. Where you have a pro-rata payment to all noteholders, until an event happens. And when that event happens, the repayment of the notes then goes sequential.

We are seeing a sharp increase in this type of transaction, which I believe implies increased tail risk especially considering the back-end nature of balloon loans and leasing products. I’d like to know what my peers think about this trend.

Why is the Securitisation Event particularly interesting for investors and market participants?

Auto ABS is not a very significant market in the Netherlands, so it will be good to spread the word somewhat in a market that may be less familiar with Auto ABS. But there has been a lot of good work done by existing market participants and I’m looking forward to talking autos in Amsterdam. The Securitisation Event is able to bring the right market participants together at one time, but it is still an intimate enough conference to be productive.

Alex Garrod is a member of the panel discussing “Auto ABS in the Netherlands and Europe” during the Securitisation Event in Amsterdam on April 21, 2022.