Ten years ago the Big Three U.S. domestic auto manufacturers--General Motors Co. (GM), Ford Motor Co., and Fiat Chrysler Automobiles N.V. (Chrysler)--and their captive auto finance subsidiaries faced uncertain futures. After losing their investment-grade ('BBB-' and above) issuer credit ratings in 2005, Ford and GM become highly dependent on the asset-backed securities (ABS) market to fund their financing operations. Chrysler LLC and its captive Chrysler Financial Corp. also became reliant on the market after Daimler AG sold them to Cerberus in 2007.

Things worsened for automakers in mid-2008 after an unprecedented spike in gas prices to over $4 a gallon depressed sales and resale values of large sport utility vehicles (SUVs) and pick-up trucks, which represented a significant portion of auto lease ABS pools. Residual losses in these transactions spiked, causing S&P Global Ratings to raise required credit enhancement levels, making lease financing more expensive for the captives. Then, in late-2008, funding costs across the entire ABS market rose precipitously due to the worst financial crisis since the Great Depression. By early 2009, access to the ABS market, even for 'AAA' rated auto loan ABS, had nearly dried up. Further, automakers' increased bankruptcy risk led to downgrades of their finance captives' dealer floorplan ABS transactions. Unable to secure affordable financing, the captives severely curtailed lending and leasing activity. This caused vehicle sales volumes to plummet and hastened the Chapter 11 bankruptcy filings of Chrysler on April 30, 2009, and GM on June 1, 2009 (see chart 1). However, the automakers' overall health has greatly improved since then: GM and Ford have regained investment-grade ratings--they are currently rated BBB/Stable/-- and BBB/Negative/A-2, respectively; and Chrysler currently has a positive rating outlook (BB+/Positive/B).

Chart 1

Certain Auto ABS Are Vulnerable To Auto Manufacturers' Bankruptcy Risks

The above events highlighted the varying degrees to which auto-related ABS are vulnerable to automakers' bankruptcy risks. In response, S&P Global Ratings recalibrated its dealer floorplan criteria by explicitly tying the credit-related assumptions to the auto manufacturers' issuer credit ratings. In auto lease ABS, we modified our residual stresses to account for the manufacturer's issuer credit rating, but only to the extent the manufacturer is rated speculative-grade ('BB+' and lower). At the same time, we adjusted our residual haircuts based on the observed deterioration in residual performance from 2008 to 2009. As a result of these criteria changes, credit enhancement has risen significantly in the auto dealer floorplan and auto lease transactions rated by S&P Global Ratings, compared to the pre-2008 transactions.

Rental car securitizations have also evolved over the past decade. Prior to Ford's and GM's downgrades to speculative grade, our ratings on these rental car transactions were generally linked to our issuer credit ratings on the auto manufacturers due to buyback agreements under which the manufacturers would buy back the vehicles (program vehicles), thereby protecting the transactions from market value and operator bankruptcy risks. After Ford's and GM's downgrades, the securitizations' credit enhancement nearly doubled. Concurrently, the rental car companies greatly reduced the percentage of program vehicles in their fleets, and we changed our rating approach for these transactions by linking our ratings on the rental fleet ABS to our issuer credit rating on the rental car company.

Of the four auto-related asset types (auto dealer floorplan, auto lease, rental car, and auto loans), auto loans are the least exposed to manufacturer bankruptcy risk. Auto loan obligor defaults are closely correlated with unemployment levels, and the number of vehicles exposed to market value risk is limited to the extent there are defaults. Due to these factors and the strong ratings performance of this asset class through the credit crisis, we did not make substantive changes to our auto loan ABS criteria.

Auto Dealer Floorplan ABS

Bankruptcies fueled changes in our rating approach

Auto dealer floorplan ABS consist primarily of loans that a captive auto finance company made to its related dealers to finance the purchase of vehicle inventory sold at their stores. These loans are secured by the vehicles on the dealers' lots and are repaid when the vehicles are sold. Our rating approach for these ABS, which generally revolve unless certain amortization events are triggered, had always assumed that the dealers' financial health was closely tied to that of the related manufacturer. Before 2009, our approach considered scenarios in which an auto dealer floorplan transaction entered early amortization after the manufacturer filed for Chapter 11 reorganization bankruptcy and a substantial portion of the underlying collateral was liquidated in an orderly fashion. At the time, we considered the possibility of an auto manufacturer filing an immediate Chapter 7 liquidation as extremely remote and did not factor it into our analysis.

However, given the business, credit, and economic factors in late-2008 to early-2009, including the dearth of financing available to insolvent companies seeking to reorganize, we changed our worst-case scenario to account for dealer floorplan transactions entering early amortization during the early stages of a manufacturer's Chapter 7 liquidation. In this scenario, financial and sales support for the dealers ceases, the auto manufacturers do not honor warrantees on new vehicles or their repurchase agreements, vehicle prices drop, and dealer defaults are more severe than in a Chapter 11 scenario. As a result, credit enhancement levels to support the then outstanding transactions rose measurably, and we downgraded many dealer floorplan transactions, including some rated 'AAA', to as low as 'BB-' (see table 1).

Table 1

Our rating approach now considers significantly more stressful scenarios than those observed in 2009. While the worst-case stress scenarios we contemplated--including Chapter 7 liquidations, rejection of buyback agreements, and automakers' failure to honor their warranties--did not occur, they could have if the U.S. Treasury had not stepped in to provide financial assistance to Chrysler and GM through its Troubled Asset Relief Program (TARP). This relief included the U.S. Treasury funding a Warranty Commitment Program that provided funding for warranties on new vehicles purchased while the automakers restructured.

Manufacturer issuer credit rating is now a key factor in determining credit enhancement

In 2009, we expanded our analysis to account for the possibility of Chapter 7 liquidations, with this liquidation being tied to the automaker's issuer credit rating. In 2015, we formalized this approach with our recalibrated criteria for non-diversified auto dealer floorplan loans, which we continue to use today (see "Global Non-Diversified Auto Dealer Floorplan Rating Methodology And Assumptions," published Feb. 5, 2015).

The underlying premise is that a dealer floorplan loan pool is less likely to suffer the more severe effects of a manufacturer liquidation (higher defaults and loss severities) if the associated manufacturer was highly rated before the liquidation. Consequently, we use the auto manufacturers' issuer credit ratings as a differentiating factor affecting the credit quality of dealer floorplan loans. This asset type is servicing intensive and complex, requiring dealer financial reviews, inventory audits, and protecting the captive's collateral through dealer bankruptcies. As a result, a liquidation of an automaker and its captive would magnify the impact of a servicer's insolvency, and hence the link to the manufacturer's issuer credit rating.

Once the pool enters amortization, the auto manufacturers' issuer credit ratings drive the stresses we apply to the two primary credit variables in our analysis: the default-to-liquidation (DTL) and the loss given default (LGD) rates (see table 2). For example, at the start of the amortization period for a 'AAA' rated dealer floorplan transaction where the manufacturer is rated 'BBB', we assume a 50% DTL rate (half of the decline in the pool balance comes from dealer defaults) and a LGD of 30%, (approximate midpoint of the specified ranges), with the resulting loss-to-liquidation rate (LTL) of 15%. The stresses increased over six months, with the LTL reaching 30%. After month six, we assume a full liquidation of the remaining collateral.

The DTL and LGD rates may vary within the ranges to account for manufacturer and dealer base-specific adjustment factors, such as the financial strength of the dealer base; and the manufacturer's overall market share and position, inventory management practices, vehicle quality and mix, manufacturer rating modifier (+/-), and competitive position relative to its peers. The assumed loss severities were calibrated based primarily on the stressed values on used vehicles in auto lease ABS.

Table 2

After arriving at the LTL rate, the absolute level of cumulative net losses (CNLs) that are modeled over the amortization period will depend on the payment rate trigger. The payment rate refers to the principal-related payments from the dealers to the trust. The higher the payment rate, the less time the receivables will be outstanding and subject to our stressed default and LGD assumptions.

Using the example above with a 'BBB' rated manufacturer, a payment rate trigger of 45% would result in a 18.6% CNL, while a much slower payment rate trigger of 15% would result in a 24.6% CNL. (For CNLs by manufacturer rating and payment rate trigger, see table 3 in "Global Non-Diversified Auto Dealer Floorplan Rating Methodology And Assumptions," published Feb. 5, 2015.) Incorporating the manufacturer issuer credit rating into our criteria means that, unlike before 2009, a tight payment trigger now cannot offset a low issuer credit rating.

The impact on credit enhancement

Recalibrating our dealer floorplan criteria in 2011 to incorporate the automakers' issuer credit ratings has led to significantly higher required credit enhancement for the auto manufacturers (see table 3).

Table 3

These credit enhancement levels also take into account the amount of dealer concentration permitted in individual transactions. Generally, these concentrations are limited to approximately 2%. Our rating methodology assumes a certain percentage of the top dealers will default and larger permitted concentrations will lead to higher credit enhancement levels, all else being equal.

Limits and future rating movements

Given the dire economic environment in late-2008 to early-2009, when it seemed probable that one of the auto manufacturers and its associated captive finance arm would liquidate, the need for a potential backup servicer became apparent. To address this risk, our criteria now limit auto dealer floorplan ABS ratings to generally six to nine notches higher than our issuer credit rating on the servicer or manufacturer, unless a formal backup servicer agreement is in place. (For more details, see the Methodologies And Assumptions: Operational And Administrative Risks section in "Global Non-Diversified Auto Dealer Floorplan Rating Methodology And Assumptions," published Feb. 5, 2005.)

Our ratings on dealer floorplan ABS can change if the manufacturer's issuer credit rating changes, based on the modeling assumptions associated with the new rating. However, we would not expect to see the same level of rating volatility we saw in 2009 if a manufacturer were to be downgraded. This is because our auto dealer floorplan criteria has aligned the modeling assumptions to be consistent with our credit stability criteria, which aims to limit a downward movement for 'AAA' and 'AA' ratings to one rating category over one year and three rating categories over three years, respectively.

Therefore, if a manufacturer incurs a three-notch downgrade, the resulting change in the auto dealer floorplan ABS rating could range from no change up to a two-notch downgrade, depending on our assessment of the rationale for the manufacturer's downgrade and any adjustments to our LTL assumptions, which are generally limited to 10% in either direction. For example, after Hyundai Motor Co. and Kia Motors Corp. were downgraded to 'BBB+' from 'A-' in October 2018, we reassessed the adequacy of the credit enhancement in their outstanding Hyundai Floorplan Master Owner Trust Series 2016-1 transaction. We used the stresses associated with auto manufacturers in the 'BBB' rating category and adjusted these to account for our assessment of Hyundai's and Kia's dealer base strength, their market shares (locally and globally), the positive modifier in the issuer credit ratings (i.e., 'BBB+'), and the overall quality and product mix of the vehicles securing the floorplan loans. As a result, we affirmed our 'AAA (sf)' and 'A (sf)' ratings on the transaction's class A and B notes, respectively.

Auto Lease ABS

Why our auto lease ABS criteria changed

Residual values on off-lease vehicles plummeted in mid-2008 due to gas prices spiking to over $4 a gallon, used vehicle financing drying up, and concerns about the survivability of the domestic automakers. As a result, residual losses exceeded the stressed levels we used in sizing credit enhancement for these transactions. Several 'AAA' rated auto lease ABS were downgraded, and several more would have been downgraded if not for the sponsors adding credit enhancement to the transactions (see table 5). But while the sponsors' support provided rating stability, our rating analysis still assumed they would not buttress a transaction if it performed worse than expected.

Table 5

Captive auto finance companies and certain other finance companies provide auto leasing to support the sale of new vehicles to consumers. A lessor's primary risk is residual risk, which occurs if the market value of the vehicle at the end of the lease term is less than the stated residual value on the lease contract. This is a concern because 100% of the vehicles could potentially be returned to lessors at lease end, especially if the residual values were artificially inflated to give the customers low monthly lease payments (commonly called subvented leases).

To address the risk of inflated residuals, residual values in auto lease ABS are generally set lower than the contract value using a base residual value. The base residual value is generally defined as the lower of the contract value at the inception of the lease and the third-party forecast (generally the Automotive Lease Guide) that was assigned to the vehicle. The residual forecast aims to eliminate incentive-based residual pricing and takes into account future expected economic factors and the associated manufacturers' planned production schedule. Continual evaluation of the accuracy of third-party residual marks is an important part of our rating analysis.

Residual loss performance

Before the gas price shock in mid-2008, our rating approach for auto lease ABS incorporated residual haircuts equal to 10% of the manufacturer's suggested retail price (MSRP) for 'AAA' ratings. Assuming the residual was sized at 70%-50% of MSRP, that equated to a 'AAA' stress relative to the residual value of approximately 14%-20%. Actual residual losses (as measured against the base residual value) during the Great Recession temporarily exceeded these stressed levels (see chart 2).

Chart 2

In 2008, as high cash incentives were placed on SUVs and pickup trucks to reduce bloated inventory levels, used values for these vehicles plummeted. Manheim Consulting reported mileage-adjusted declines in used vehicle prices for large SUVs and pickup trucks of 28% and 25%, respectively, for the 12 months ended June 30, 2008. During the stressed economic period beginning in mid-2007 and ending in mid-2009, the residual losses for the auto lease ABS pools we rated averaged approximately 9.3% off the base residual value, and the worst three-month rolling average was approximately 17.9% (see chart 2).

Residual losses could have been much worse if the U.S. government had not stepped in and done the following:

• Provided TARP financing, which allowed GM and Chrysler to reorganize in Chapter 11 rather than liquidate;
• Funded the Warranty Commitment Program to cover most of the warranty costs associated with new vehicles while the automakers restructured; and
• Sponsored the "Cash for Clunkers" program from July through November 2009, which boosted used-vehicle values and residuals by eliminating approximately 700,000 used vehicles from circulation.

Changing our rating approach to incorporate auto manufacturers' issuer credit ratings

We used the observed performance during the Great Recession to recalibrate our auto lease criteria as follows:

• We determined that haircuts of 13% and 26% off the base residual value would be commensurate with 'BBB' and 'AAA' rating stress scenarios, respectively, which we apply over the entire life of the transaction for all non-defaulting leases;
• We included additional residual stresses and haircuts for various forms of concentration risk, including lease maturity, model, new or discontinued vehicles, and vehicle segment (such as compact cars, pickup trucks, or SUVs); and
• We applied additional stress if the manufacturers of the vehicles in the pool have speculative-grade issuer credit ratings.

For speculative-grade manufacturers, we apply an incremental residual value haircut that is intended to capture the additional stress a manufacturer bankruptcy could have on vehicle values. In addition to the residual value (13% for 'BBB' and 26% for 'AAA') and excess concentration haircuts, we apply the haircuts shown in table 6 to the base residual value of the vehicles produced by these manufacturers.

Table 6

As a result of our recalibrated criteria in 2011, credit enhancement has increased significantly for auto lease ABS (see table 7).

Table 7

Future rating movements

Because our auto lease criteria include a residual stress test that is linked to the auto manufacturers' issuer credit ratings, our ratings on an auto lease ABS transaction could change if the manufacturer's issuer credit rating changes. However, our analyses of these transactions place more weight on actual residual performance than on the pool concentrations as the leases become more seasoned. Additionally, unlike auto dealer floorplan transactions, which are revolving, auto lease ABS typically amortize immediately by using the monthly lease payments and residual payments to retire the notes. This, coupled with the build in overcollateralization and sequential pay structure, allows credit enhancement to grow significantly over time. Given these factors, strong lease performance could offset the risk posed by a manufacturer downgrade, depending on the circumstances and degree of the downgrade.

In future recessions, we don't expect 'AAA' auto lease ratings to fall as steeply as they did during the Great Recession. Although in 2009 we downgraded a few auto lease ABS classes within one to two years of issuance to 'BBB' from 'AAA', our recalibrated auto lease criteria now apply greater residual stresses, which should prevent this. The stresses are augmented by additional residual haircuts to address maturity, make, and both low- and high-MPG (miles per gallon) vehicle concentrations in the event gas prices rise or fall significantly. The updated criteria also include an additional residual haircut for investment-grade classes if the vehicles' manufacturer has a speculative-grade issuer credit rating. Moreover, these transactions need to pass our 2010 rating stability criteria before they are assigned a rating (see "Methodology: Credit Stability Criteria, published May 3, 2010). That is, under a 'BBB' stress scenario, a 'AAA' rating would not be lowered by more than one rating category in the first year or more than three rating categories over three years.

Rental Car ABS

How automakers' downgrades and the resulting shift away from program vehicles changed our rating approach

Rental car securitizations, including those by large fleet operators such as Hertz Corp., are secured by a lease of the fleet to the operator and the underlying vehicle fleet. Before Ford and GM lost their investment-grade ratings in 2005, most of these fleet securitizations relied on manufacturer buyback agreements (program vehicles) to insulate the deals from market value and operator bankruptcy risks. Ford and GM assumed the market value risk in these transactions by setting a floor on the price they would pay to buy back the used vehicles, according to their manufacturer agreement. Because of this dependence on the buyback agreements and their prevalence, the ratings on most rental fleet securitizations were linked to the auto manufacturers' issuer credit ratings.

After Ford and GM were downgraded to below 'BBB-', the manufacturer buyback agreements no longer appropriately mitigated the potential decline in the rental vehicles' market values. S&P Global Ratings continued to rate these transactions for some time, but their credit enhancement nearly doubled to account for the portion of the pools consisting of program vehicles from speculative-grade manufacturers and the higher stress assumptions for additional market value risk, after considering manufacturer insolvency. The rental car companies adjusted to the auto manufacturers' downgrades by gradually reducing the percentage of program vehicles in their fleets.

In 2009, we began incorporating stability tests into our ratings and changed our rating approach for rental fleet securitizations to link the rental fleet ABS ratings to the rental car company's issuer credit rating. We believe the creditworthiness of these transactions and the stability of the ratings are closely tied to the financial health of the rental car company. This reflects the unique nature of these transactions, in which the entire fleet of vehicles is leased and serviced by one obligor--the rental car company.

We believe these transactions' single obligor risk is inconsistent with the credit stability we expect for 'AAA' and 'AA' ratings. Indeed, during the financial crisis, we lowered Avis Budget's and Dollar Thrifty's issuer credit ratings to the 'CCC' category. According to our current criteria, if the rental car company's issuer credit rating is lower than 'BBB-', the highest stand-alone rating we would assign to the rental fleet ABS is 'A (sf)', but only to the extent that servicing risk is mitigated. A potential mitigant is the engagement of a back-up servicer or a disposition agent, which would be responsible for repossessing and liquidating the vehicles in the event the rental car company enters bankruptcy and liquidation of the rental fleet is necessary to repay the rental fleet ABS. (For more on rental car securitizations, see "Revised Global Methodology For Rating Rental Fleet ABS," published June 29, 2009.)

The U.S. rental car market, which accounts for approximately 2.2 million vehicles in service, is highly concentrated among three companies. Enterprise Holdings Inc. (A-/Stable/A-2), the largest global and U.S. car rental company (which comprises the Enterprise, National, and Alamo brands) has historically financed its vehicles on an unsecured basis. The other two large rental car companies, Hertz Corp. (B+/Stable/--), which acquired the Dollar and Thrifty brands in 2012) and Avis Budget Group Inc. (BB/Stable/--), access the ABS market for funding, but we haven't rated any of their transactions recently (our rating criteria for this asset class would cap these companies' ABS ratings below 'AAA'). Combined, these three companies account for well over 90% of the U.S. on-airport car rental market.

Auto Loan ABS

Resilient through the Great Recession

Despite the unemployment rate doubling to 10% in two years, used vehicle values sinking, and weaker underwriting leading to higher-than-expected CNLs, auto loan ABS weathered the Great Recession well, with upgrades surpassing downgrades by a wide margin (see table 8).

The positive ratings performance reflected several factors:

• The transactions usually employ a sequential-pay mechanism in which the most senior class of notes is repaid first, causing subordination to grow as a percentage of the declining pool balance.
• The transactions' initial overcollateralization typically builds to a specified target, providing more hard credit enhancement than at closing.
• To the extent the overcollateralization and reserve accounts are fully funded, their floors, once operative, provide an increasing percentage of credit enhancement relative to the declining pool balance.
• Most of the transactions we rated in 2006 through 2008 realized lower CNLs than we had assumed in our 'BBB' stressed case scenarios.

Table 8

Of the of Big Three U.S. domestic automakers, Chrysler's transactions performed the worst and saw some of its transactions placed on CreditWatch with negative implications. However, the company provided additional credit enhancement to certain of these transactions and, as a result, only one of its transactions was downgraded (see table 9).

Table 9

None of the deals from the other auto captive finance companies (including foreign captives) were downgraded, although some contributed additional credit enhancement to support the assigned ratings at the time. In total, seven transactions from four issuers received additional credit enhancement (for more details, see "U.S. ABS Credit Ratings Would Have Remained Relatively Stable Even Without Additional Support," published Jan. 25, 2010).

Due to auto loan ABS' strong rating performance through the Great Recession, including Chrysler's and GM's bankruptcies, we did not recalibrate or change the major elements of our auto loan ABS criteria. However, we did make two minor changes. One change was the implementation of a minimum credit enhancement percentage for rated debt: 4% for 'AAA', 3% for 'AA', 2% for 'A', and 1.8% for 'BBB'. The other change was the implementation of our rating stability criteria.

Subprime Auto ABS

Speculative-grade issuance growth and weaker structural protections could lead to more rating volatility

One major change for subprime auto ABS over the past decade has been the replacement of bond insurance with internal forms of credit enhancement. Prior to 2008, most subprime issuers relied on bond insurance as the primary form of credit enhancement for their 'AAA' rated transactions. However, from 2008 to 2010, bond insurer downgrades led to many auto ABS downgrades. At the same time, subprime issuers faced liquidity issues as lenders and the debt market shunned riskier forms of lending. This led to a significant contraction in the number of subprime auto loan ABS issuers.

After the recession, as the economic recovery strengthened, market participants adjusted to the lack of bond insurers. The number of subprime issuers receiving ABS standalone ratings from S&P Global Ratings increased to 18 in 2018 from only three (AmeriCredit, Credit Acceptance, and CPS) in 2008. Many of the new issuers first came to the market with capped ratings of 'A (sf)' or 'AA (sf)', but over time, some have achieved 'AAA (sf)' ratings. Credit enhancement for these deals have been provided through the structure, with 'AAA (sf)' rated bonds being able to withstand approximately 70%-93% in cumulative gross losses, depending on the base-case loss level.

The bond insurers' departure has resulted in fewer structural protections, including performance triggers. Some of these triggers, if breached, increase the amount of credit enhancement available to noteholders, depending on how tightly they are structured. Also, without the structuring influence and the control party responsibilities of the bond insurers, there is more risk should the servicer encounter financial or other difficulties. Previously, poor pool performance or weak servicer financial results would allow the bond insurer to replace the servicer. Those provisions have been removed, making it more difficult to transfer servicing quickly in advance of more serious credit deterioration. Further, the bond insurers had more stringent conditions regarding extensions and modifications than we see today in subprime auto loan ABS transaction documents. The looser standards potentially expose subordinated investors to more back-end credit risk.

Given the absence of bond insurers as control parties and key structuring agents, and the proliferation of speculative-grade classes in subprime autos, we believe speculative-grade subprime auto loan ABS are now more susceptible to downgrades than in the past. Further, these can occur outside of a recession due to idiosyncratic servicer- and originator-related issues, as was the case with the Honor 2016-1 transaction (see "Honor Automobile Trust Securitization 2016-1 Class B Notes Placed On Watch Negative, Class C Downgraded," published Nov. 19, 2018).

Related Criteria

• Global Non-Diversified Auto Dealer Floorplan Rating Methodology And Assumptions, Feb. 5, 2015
• Revised General Methodology And Assumptions For Rating U.S. ABS Auto Lease Securitizations, Nov. 29, 2011
• ABS: General Methodology And Assumptions For Rating U.S. Auto Loan Securitizations, Jan. 11, 2011
• Methodology: Credit Stability Criteria, May 3, 2010
• ABS: Updated General Methodology And Assumptions For Rating U.S. Rental Fleet Securitizations, Aug. 1, 2011

Related Research

• Three Ratings Affirmed On Hyundai Floorplan Master Owner Trust Series 2016-1, Jan 7, 2019
• Honor Automobile Trust Securitization 2016-1 Class B Notes Placed On Watch Negative, Class C Downgraded, Nov. 19, 2018
• U.S. ABS Credit Ratings Would Have Remained Relatively Stable Even Without Additional Support, Jan. 25, 2010