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Auto ABS: Turbocharged or Stuck in Neutral?
Friday, April 08 2011 | 07:08 AM
SNR DENTON US LLP
|On March 29, 2011, several federal agencies issued a notice of proposed rulemaking (NPRM) to implement the Dodd-Frank Wall Street Reform and Consumer Protection Act provisions regarding mandatory risk retention by “securitizers” of various asset classes. The Act established a baseline five percent risk retention, but authorized the agencies to establish higher (or lower) thresholds for identified asset classes. In the NPRM, auto loans received particular attention. The question remains whether the agencies’ proposals will turbocharge auto ABS--or leave it stuck in neutral.
Page 159 of the NPRM proposes “a zero percent risk retention requirement (that is, the sponsor would not be required to retain any portion of the credit risk) for ABS issuances collateralized exclusively by loans from one of the asset classes specified…and which meet the proposed underwriting standards.”
The good news is that the agencies recognized that “establishing a risk retention requirement between zero and five percent…may not sufficiently incent [sic] securitizers to allocate their resources necessary to ensure that the collateral backing an ABS issuance satisfied the proposed underwriting standards”. Other welcome news is that the NPRM added that “[t]o facilitate compliance…supervision and enforcement of the rule, the proposed standards are generally prescriptive, rather than principle-based.” That enables securitizers to avoid a regulatory guessing game.
However, ABS sponsors who have included commercial auto loans or leases in their securitized pools will be disappointed at the narrow approach taken by the agencies “to establish conservative requirements that are consistent with underwriting standards commonly used by the industry for unsecured [emphasis added] installment credits.” The proposed rules would exclude any lease financing and any loans to finance fleet sales or the purchase of a commercial vehicle. So the reduced risk retention would appear to be available to the larger auto consumer finance companies and not to ABS sponsors which finance commercial auto loans and leases.
The rules would force originators to determine that each obligor has a monthly total debt to income ratio of less than or equal to 36%. Documenting this analysis will require the originator to obtain data from each obligor about his monthly housing payments and other amortizing payments, credit card and lease obligations, alimony, child support and other court-ordered payments. Beyond this potentially intrusive investigation, the proposed rules would restrict qualifying auto loans to those with a fixed interest rate, maximum five year term using straight-line monthly amortization, and 20% minimum down payment. Each originator and securitizer will have to make its own determination whether these and other standards in the proposed rule are practical and worthwhile to obtain zero risk retention for any auto ABS issuance.
Because of the high likelihood that a few loans in the securitized pool could fail to meet the agencies’ standards, the proposed rules require the depositor to certify as to “the effectiveness of its internal supervisory controls for ensuring all of the loans backing the ABS are qualified loans” and the sponsor to (a) repurchase nonqualifying loans within 90 days “after the determination that the loans do not satisfy the underwriting standards” and (b) disclose to the ABS investors the loans which are repurchased and the cause for each repurchase. Much of this is customary in auto ABS, but the agencies ominously “seek comment on whether the sponsor should be required to repurchase the entire pool of loans [emphasis added] collateralizing the ABS if the amount or percentage of the loans that are required to be repurchased…reaches a certain threshold.” If adopted, this imposition would be a dramatic departure from industry practice.
The comment period for the proposed rules runs through June 10, 2011.
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Restarting CMBS Lending
Wednesday, March 30 2011 | 08:53 AM
|The DDR deal, the first CMBS deal after nearly eighteen months, was ten times oversubscribed. The following two deals also saw good demand even though they did not allow for TALF financing. So, clearly, there is good demand for CMBS bonds backed by well underwritten loans. Also, borrowers clearly want loans if they can get a reasonable cost of financing. DDR loan, with about 4.25% all-in cost of financing for the borrower, showed that a low cost of financing is possible even in the current market. Yet, prospects of a conduit style multi-borrower deal seem bleak at the moment. Any CMBS deals that come to market are expected to be single-borrower deals, as in those deals the borrower takes the market risk and not the underwriter doing the deal. Securitization shops do not want to take the spread risk while aggregating the pool because there is no way to hedge that risk, and so are unable to originate loans even though many are eager to restart their lending operation. If they do originate loans without ability to hedge, they would require much wider spread resulting in higher cost of financing than borrowers would find attractive.
Inability to hedge loans while aggregating a pool for securitization is one of the biggest obstacles preventing restarting of conduit lending for commercial real estate properties.
In the past, the conduit originators were able to hedge loans while they were aggregating a pool big enough to securitize. So, they were not exposed to risk from changes in interest rates and bond spreads between loan origination and securitization. The hedging generally involved hedging the interest rate risk by selling interest rate swaps, and hedging the bond spread risk by using Total Return Swaps on Lehman or Bank Of America CMBS indices. These indices allowed loan originators to effectively sell their risk to investors who wanted to gain exposure to CMBS in their investment portfolio. They sold the risk when they originated the loan, and bought it back when they securitized the loans. The hedge worked because spreads on new CMBS deals moved in parallel with the spreads on existing deals.
The problem now is that those indices are no longer appropriate for hedging, especially for new origination loans, because of two problems. One, ratings downgrades have impacted the composition of the indices. Second, and more important, the spreads on new bonds with newly underwritten loans cannot be expected to move in tandem with spreads on old bonds with the old underwriting. This lack of correlation between the two spreads makes the old bonds or indices unusable as a hedge for newly originated better quality loans.
What this means is that to hedge new loans with better underwriting, originators need bonds with better underwritten new loans. In other words, to originate loans, you need bonds with new underwriting, and to create bonds with better underwritten loans, you need the better underwritten loans. That’s the chicken-and-egg type problem of loan aggregation. This is what has prevented loan origination from restarting once the spreads on old bonds widened out.
To solve this chicken-and-egg problem, back in February 2008, I made a suggestion to Markit, which administers the CMBX indices. My suggestion was to create a new CMBX type of index based on future deals that met minimum credit quality. Only deals which met pre-set criteria based on LTV, DSCR, and other credit parameters would be eligible to be included in the new index. Trading of the index would have allowed the market to determine spreads on bonds backed by good newly originated loans, and provided a hedging mechanism for loan originators, solving the chicken-and-egg problem.
Markit discussed the idea in a conference call with the trading desks, but it was thought to require too much work to create, when dealers were busy with the market volatility. Also, the idea was complicated, since it was based on future deals. Additionally, the CMBX is based on CDS (Credit Default Swap), and cash and CDS markets do not always move together, and so the hedge would not have been as good as Total Return Swaps on cash bonds.
Luckily, things have changed since then.
One, Markit has created new indices called TRX, which are based on Total Return Swaps on cash CMBS spreads, which will be a much better hedge for loans than a CMBX or CDS type of hedge. Total Return Swaps are what many originators used in the past to hedge the credit spreads.
Second, new deals with newly underwritten loans have been done and exist now. So, it is not necessary to base the index on future deals, avoiding a lot of complexity. That simplifies things considerably.
One solution to the hedging problem for newly originated loans is to create a new TRX index based on the new deals. It will allow the originators to sell risk, and will allow all the investors (many who did not get any allocations in the over-subscribed deals that have been done recently) to get exposure to new CMBS bonds.
Some may argue that three deals is not enough diversity to create an index. Admittedly, it would be better to have a more diverse pool of deals for the index. However, even with just three deals, the index will allow many originators considering starting origination to solve the chicken-and-egg problem. Also, this by itself will not solve all the problems the CMBS industry is facing. Yet, it will be better to have something, even if it is not perfect, than to have nothing at all.
I urge Markit and the dealers to make available a new index that will be attractive to both loan originators and investors, and just might help solve one of the major roadblocks preventing restarting of CMBS lending.
Note: This article was published on Seeking Alpha.
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