Rating U.S. Retail Auto Loan Securitizations - Methodology august 2013
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Methodology Rating U.S. Retail Auto Loan Securitizations august 2013
CONTACT INFORMATION GLOBAL STRUCTURED FINANCE — ABS Chris D’Onofrio Chuck Weilamann Senior Vice President Senior Vice President Tel. +1 212 806 3284 Tel. +1 212 806 3226 cdonofrio@dbrs.com cweilamann@dbrs.com Chris O’Connell Claire Mezzanotte Senior Vice President Group Managing Director Tel. +1 212 806 3253 Tel. +1 212 806 3272 coconnell@dbrs.com cmezzanotte@dbrs.com GLOBAL STRUCTURED FINANCE — OPERATIONAL RISK Kathleen Tillwitz Stephanie Whited Senior Vice President Senior Vice President Tel. +1 212 806 3265 Tel. +1 347 226 1927 ktillwitz@dbrs.com swhited@dbrs.com GLOBAL STRUCTURED FINANCE — RESEARCH AND MODELING Jan Buckler Senior Vice President Tel. +1 212 806 3925 jbuckler@dbrs.com DBRS is a full-service credit rating agency established in 1976. Privately owned and operated without affiliation to any financial institution, DBRS is respected for its independent, third-party evaluations of corporate and government issues, spanning North America, Europe and Asia. DBRS’s extensive coverage of securitizations and structured finance transactions solidifies our standing as a leading provider of comprehensive, in-depth credit analysis. All DBRS ratings and research are available in hard-copy format and electronically on Bloomberg and at DBRS.com, our lead delivery tool for organized, Web-based, up-to-the-minute infor- mation. We remain committed to continuously refining our expertise in the analysis of credit quality and are dedicated to maintaining objective and credible opinions within the global financial marketplace.
Rating U.S. Retail Auto Loan Securitizations
August 2013
Rating U.S. Retail Auto Loan Securitizations
TABLE OF CONTENTS
Executive Summary 4
Retail Auto Loan ABS Industry Overview 4
Collateral Description 5
Operational Risk Review 8
Transaction Structures 11
ABS Financial Structure 13
Collateral Quality 17
Cash Flow Analysis 22
Appendix 1: U.S. Auto Loan Originator Review Agenda 26
3Rating U.S. Retail Auto Loan Securitizations
August 2013
Executive Summary
DBRS evaluates both qualitative and quantitative factors when assigning ratings to U.S. retail auto loan
asset-backed securities (ABS) transactions. The key analytical considerations evaluated by DBRS include
the following:
• Quality of originations and underwriting practices;
• Quality of servicing capabilities;
• Collateral quality analysis;
• Capital structure, target ratings and credit enhancement;
• Cash flow scenario analysis; and
• Legal structure and opinions.
In the analysis of U.S. retail auto loan ABS transactions, DBRS evaluates the risk to the loans related to
the performance of the originator and servicer of the auto loan assets by performing an operational risk
review and assessment of key parties involved in the origination and servicing to provide insight into the
manner in which these processes have impacted past auto loan pool performance and to assist in estab-
lishing loss expectations for a proposed pool.1
For each target rating, DBRS analyzes the proposed transaction cash flow structure under various stress
scenarios to determine the ability of the transaction to repay timely interest and ultimate principal in
accordance with the terms of the transaction.
DBRS reviews the transaction’s legal structure and opinions to assess that all necessary steps have been
taken and no subsequent actions are needed to protect the issuer’s ownership interests of the assets.
Retail Auto Loan ABS Industry Overview
The U.S. retail auto ABS sector consists of transactions that are supported by pools of retail installment
sales contracts issued to consumers of varying credit quality. The two major types of pools that typically
support U.S. retail auto ABS transactions consist of prime and sub-prime quality obligors.
The securitization of auto loans started with pools of loans to prime obligors and has grown to include
pools of loans to sub-prime obligors. The typical prime obligor is a consumer with an average credit score
that is higher than 680 and has a consistent and stable credit history. Sub-prime obligors are consumers
that have troubled credit histories and typically have average credit scores of 680 and below.
Historically, annual U.S. retail auto loan ABS issuance averaged approximately $75 billion from 2000 to
2006, with peak issuance occurring in 2005 in the amount of approximately $87 billion. As a result of the
financial crisis, U.S. retail auto ABS issuance slowed during the end of 2007, reducing the issuance volume
to approximately $53 billion for that year. Aided by the introduction of the Federal Reserve’s Term
Asset-Backed Securities Loan Facility (TALF)2 in 2008, issuance resumed and experienced consistent year-
over-year increases since 2008 with approximately $37 billion issued in 2008 and approximately $63
1. Please refer to the DBRS methodology Operational Risk Assessment for U.S. ABS Servicers.
2. The Federal Reserve created TALF to help market participants meet the credit needs of households and small busi-
nesses by supporting the issuance of ABS collateralized by auto loans, student loans, credit card loans, equipment loans,
floorplan loans, insurance premium finance loans, loans guaranteed by the Small Business Administration, residential
mortgage servicing advances or commercial mortgage loans. The facility began operations in March 2009 and was
closed for new loan extensions against newly issued commercial mortgage-backed securities (CMBS) on June 30, 2010,
and for new loan extensions against all other types of collateral on March 31, 2010.
4Rating U.S. Retail Auto Loan Securitizations
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billion in 2012. Prior to the credit crisis in 2007, total issuance was comprised of approximately 67% of
transactions supported by prime collateral and approximately 33% supported by sub-prime collateral.
In 2012, prime issuance was comprised of approximately 73% of total issuance volume and sub-prime
volume totaled approximately 27%.
To date, the issuance of U.S. retail auto loan ABS transactions supported by pools of loans to prime-qual-
ity obligors have been dominated by captive finance subsidiaries of the automobile manufacturers. Prime
transactions have also been completed by independent non-captive finance companies, credit unions and
banks. Transactions backed by pools of prime obligor loans have generally experienced cumulative net
losses in the 3% or less range with a majority of transactions experiencing losses in the 1% to 2% range.
The sub-prime auto ABS market dates back to the early 1990s and has traditionally been made up of
independent finance companies and banking institutions with national platforms. The sub-prime auto
loan originators indirectly purchase auto loan contracts from franchise and independent automobile
dealerships. Similar to the volume of prime auto ABS issuance, sub-prime auto ABS issuance volume
experienced consistent growth since inception, with sub-prime auto ABS issuance volume peaking in
2005. A change in the economic environment resulting from the financial crisis led to a reduction in the
number of active lenders through consolidation or lenders exiting the industry.
Typical sub-prime auto loan collateral experiences cumulative net losses that range from 4% to 25% or
higher. Sub-prime auto loan types may be broken down into sub-categories mainly based on performance.
These categories include near-prime, sub-prime, deep sub-prime and buy-here-pay-here. Each category
within the sub-prime sector has unique characteristics and presents different risks.
Collateral Description
The U.S. retail auto loan ABS market has evolved over time and is a fundamental component in the U.S.
structured finance capital markets. While the auto ABS market has developed, the collateral backing the
ABS transactions has remained consistent with only minor changes to certain loan and/or obligor char-
acteristics. Analysis of a transaction’s collateral is a major component of the assessment of the risk of
a proposed transaction. DBRS analyzes the underlying collateral and assesses the characteristics of the
loans to determine a proposed pool’s expected loss. DBRS may also analyze loan characteristics related to
the loan terms, the obligors and the vehicles securing the loan.
LOAN CHARACTERISTICS
An auto loan is a contractual agreement between an obligor and a lender and typically is in the form
of a retail installment sales contract. The retail installment sale contract is a secured loan whereby the
obligor pledges the financed vehicle as collateral. Auto loans typically amortize so the entire amount of
the loan is repaid at a predetermined rate over the life of the loan. A lien is noted on the financed vehicle’s
title and the ownership of the vehicle remains on the balance sheet of the lending institution until the car
loan is paid off in full and the lending institution removes the lien. If the obligor is unable to make loan
payments, the lending institution can repossess the vehicle from the obligor.
Loan Structure
Auto loans are typically level-pay installment loans payable over a predetermined loan term at a fixed
rate of interest. An auto loan may also be structured as a balloon, whereby the obligor will be responsible
for a substantive payment at the end of the loan term. A balloon loan, like a lease, has the advantage of
low monthly payments during the term of the loan, requiring a substantially lower capital outlay during
the life of the loan when compared to fully amortizing level-pay loans. However, there is a large payment
required at the end of the loan term. The large payment due by the obligor may expose a lender to an
5Rating U.S. Retail Auto Loan Securitizations
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increased potential loss depending upon the value of the vehicle relative to the final payment amount. The
vehicle’s value may impact the obligor’s willingness to make the final balloon payment.
Original Term
The original term to maturity of auto loans typically range from 12 to 84 months; however, a majority
of securitized loans have an original term to maturity of 60 to 72 months or fewer. Loan term is often
used strategically by lenders, extending a loan’s term to help solve for a suitable monthly payment for
the obligor. Longer-term loans have become more common and account for an increasing percentage of
loans being securitized. Collateral pools with loans that have original terms to maturity of longer than 72
months may have a higher expected loss.
Financing Rate
The annual percentage rate (APR) of a loan is the rate of interest charged to the obligor and it is determined
based on a variety of factors including the market environment, prevailing interest rates and the perceived
risk of the loan. Loans that are characterized by the loan’s underwriter as higher risk typically have a higher
APR when compared to less risky loans. The APR charged to a sub-prime obligor is typically higher than
that of a prime obligor, given the perceived risk associated with an obligor that has experienced a challenged
credit history. APRs charged for the riskiest obligors may be limited by state usury law limits.
The APR charged to prime consumers may be influenced by incentive programs offered by a vehicle man-
ufacturer. In an effort to increase sales, vehicle manufacturers through their captive finance companies,
commonly offer incentives to customers through a reduced interest rate (Subvented Loans). Subvented
Loans are typically offered to higher credit quality obligors and can result in a dramatic reduction of
interest rates on the loans. Interest rates on Subvented Loans may be as low as 0%.
Down Payment and Advance Rates
The amount of leverage associated with a loan relates to the equity position that the obligor has at the
origination of the loan. The leverage is measured as a loan-to-value (LTV) ratio and typically is expressed
as a percentage of the vehicle’s value. The vehicle value may be the manufacturer’s suggested retail price
(MSRP), the wholesale value of the vehicle at the time of the purchase or another valuation method.
The financed amount typically includes the sale amount (less the value of any trade) plus taxes, insur-
ance, extended warranty or other fees, less any cash down payments. In some cases, remaining financed
amounts related to an outstanding loan may be included in the new loan amount. The lower the LTV, the
more equity the obligor has in the vehicle. Loans with higher LTVs and/or vehicles that experience rapid
depreciation may cause the obligor’s equity to be negative. If a vehicle is repossessed during this period of
negative equity value, a lender may incur a loss. The amount of the loss would be the difference between
the current outstanding loan amount and the proceeds after paying related disposition costs.
OBLIGOR CHARACTERISTICS
The credit characteristics of the obligors in a pool of auto loans can vary by transaction and pool. Credit
scores provided by third-party credit agencies are widely used by auto lenders as a measure of an obli-
gor’s creditworthiness. Additionally, many lenders in the auto finance industry utilize proprietary models
in their credit and underwriting decision process. The lender models may consider additional variables
versus those used by the credit agencies in the determination of the credit scores (such as prior payment
history with the company and loan terms) and are typically tailored to originate loans that fit the origina-
tor’s target loan and desired demographics.
The amount of leverage that an obligor has relative to their monthly income is also considered. There are
two ratios that are considered by lenders in the origination of a loan to an obligor, the debt-to-income
ratio (DTI) and the payment-to-income ratio (PTI). The DTI measures an obligor’s total monthly debts
as a percentage of the obligor’s monthly income. The PTI ratio measures the payment amount of the
proposed loan as a percentage of the obligor’s monthly income.
6Rating U.S. Retail Auto Loan Securitizations
August 2013
Geographic concentration of borrowers is considered in the assessment of a proposed pool’s risk of loss.
Collateral pools that contain high percentages of borrowers in the same geographic area may subject the
transaction to an increased exposure to loss. The increased exposure to loss may be related to isolated
economic stresses, such as increases in a state or other geographic area’s rate of unemployment.
VEHICLE CHARACTERISTICS
The vehicles securing the loans included in an ABS transaction may be considered in the assessment of the
risk of loss on a proposed pool. If the value of the vehicle securing the loan is impaired, the recovery value
in the event of an obligor default will be reduced. DBRS may assess the collateral pool for concentrations
of characteristics, such as loans secured by new or used vehicles, the average age of the vehicles, average
mileage and concentrations of vehicle makes or models.
New and Used
Auto loans can be secured by either new or used vehicles. The securitization of used vehicles occurs
with both prime and sub-prime pools, with a majority of sub-prime pools typically containing a large
portion of loans secured by used vehicles. Used vehicles typically have flatter depreciation curves than
new vehicles during the life of a loan; however, pools with loans secured by used vehicles often experience
higher losses. In the assessment of the risk of loss of a collateral pool, DBRS analyzes the concentration
of new versus used vehicles.
Make and Model
Vehicle make and model is a major factor in the value of a vehicle during the life of a loan. A vehicle’s
depreciation is the single largest reason for the decline in a vehicle’s value. Depreciation levels vary by
manufacturer, vehicle make and model. They can also be influenced by prevailing market conditions and
prices. High gasoline consumption vehicles can be subject to accelerated depreciation in times of rising
gasoline prices. Additionally, depreciation patterns can change if a certain make or model becomes dis-
continued or a manufacturer’s ability to maintain warranty coverage becomes impaired or is perceived to
be impaired. As a result, it is beneficial to ensure that vehicles collateralizing a securitized pool are diversi-
fied across make, model and manufacturer.
Other considerations evaluated by DBRS in the assessment of risks associated with a proposed pool
include the age and mileage of a vehicle securing the loans. In each case, the vehicle’s age and mileage may
have a direct impact on the value of the vehicle at liquidation. Older vehicles and/or vehicles with higher
mileage will typically be worth less at liquidation.
7Rating U.S. Retail Auto Loan Securitizations
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Operational Risk Review
OVERVIEW
DBRS operational risk assessment procedures are designed to evaluate the quality of the parties that origi-
nate the loans being securitized. While DBRS does not assign formal ratings to these processes, it does
conduct operational risk reviews and incorporates the results into its rating analysis. In instances where it
is determined that the originator is below average, certain structural enhancements may be incorporated
into an ABS transaction, such as additional credit support, dynamic triggers or the presence of a strong
backup servicer in order for DBRS to rate the transaction. In the event that DBRS determines that an
originator is unacceptable, it may refuse to rate the deal.
ORIGINATOR REVIEW
DBRS begins the initial originator review process by scheduling a date to conduct an on-site visit of the
company. Once a date is confirmed, DBRS sends a sample agenda that outlines the topics to be covered
during the meeting, which includes items such as organizational charts, financial statements, underwriting
guidelines and performance statistics.3 During the on-site review, DBRS meets with senior management to
discuss the origination operations, tour the facilities and review system demonstrations, as appropriate.
DBRS assesses the information gathered through the review process, along with its surveillance data and
industry statistics to determine if an originator is acceptable.
The originator review process typically involves a review and analysis of the following:
• Company and management,
• Financial condition,
• Controls and compliance,
• Origination and sourcing,
• Underwriting guidelines and
• Technology.
COMPANY AND MANAGEMENT
DBRS believes that no origination operation can be successful without a strong seasoned management
team that possesses demonstrated expertise in the product(s) they are originating. As a result, DBRS views
favorably those originators whose management team possesses greater than ten years of industry experi-
ence. Additionally, DBRS believes the participation of the credit risk management, quality control, legal
and compliance departments in all aspects of the origination and underwriting process is important in
order to identify and mitigate risk. Furthermore, adequate capacity and resources to handle fluctuations
in loan volume are of paramount importance.
FINANCIAL CONDITION
DBRS reviews the originator’s financial condition to determine whether the originator has sufficient
resources to make the appropriate representations and warranties on the loans being included in a
securitization.
In cases where DBRS does not maintain a public rating of the entity performing an origination role, the
DBRS Financial Institutions Group provides an internal assessment or a private rating for the relevant
institution.
3. For a detailed list of items included in the originator review for an auto loan ABS issuer, please refer to Appendix 1.
8Rating U.S. Retail Auto Loan Securitizations
August 2013
Certain items that are reviewed as part of this process may include:
• Company ownership structure,
• Management experience,
• Corporate rating of any parent company (if applicable),
• Internal and external audit results,
• Revenue sources and lines of credit,
• Costs to originate,
• Litigation (past, present and expected),
• Existing business strategy and strategic initiatives,
• Recent or planned mergers or acquisitions,
• Recent or planned transfers or acquisitions and
• Securitization history and future plans.
Any financial stress identified can elicit originator problems either immediately, as in the case of a bank-
ruptcy, or lead to a slow degradation of the performance of the collateral. Therefore, the originator’s
financial condition weighs on all aspects of DBRS analysis of U.S. retail auto ABS transactions and the
presence of compensatory structural elements.
CONTROLS AND COMPLIANCE
DBRS believes internal assessments and quality-control reviews conducted by an auto finance company
are critical in recognizing procedural errors that may not be easily detectable. These reviews can be used
to identify trends, training opportunities and exception practices. Frequent checks can assist management
in quickly instituting changes to areas needing improvement, as well as benchmarking those results to per-
formance. In addition to the aforementioned reviews, a monitoring process should be in place to ensure
that the originator is in compliance with all applicable laws, rules and regulations and that all employees
in customer-facing positions are appropriately trained.
DBRS views favorably the participation of the credit risk management, quality control, legal and com-
pliance departments in all aspects of the origination and underwriting process in order to identify and
mitigate attendant risks. DBRS also views favorably those originators that are not the subject of any
regulatory or state investigation(s). Minimal or no repurchases due to breaches of representations and
warranties are considered of paramount importance, as are the existence of robust procedures for vendor
selection and oversight. Additionally, strong controls for managing potential conflicts of interest associ-
ated with parties to a transaction are important.
SALES AND MARKETING
DBRS reviews the origination and sourcing channels to determine if the originator has a clearly defined
strategy. Origination practices that include regular performance tracking and quality control reviews are
viewed favorably by DBRS. Furthermore, procedures that ensure new account setup accuracy and data
integrity are fundamental to ensuring minimal errors. As a result, DBRS views favorably those origina-
tors with a high level of automation and strong efforts toward compliance with regulatory guidelines and
industry best practices. Furthermore, the originator’s portfolio is reviewed for changes in size, product
type or performance (such as delinquencies and first pay defaults) to determine if more frequent reviews
or management calls might be necessary for DBRS to monitor the performance of the portfolio.
UNDERWRITING GUIDELINES
An originator’s appetite for risk and the underlying quality of its underwriting guidelines can have a
significant impact on transaction performance. Therefore, DBRS uses both a qualitative and quantitative
approach to conduct its originator reviews and make comparisons among originators. Historical loan
performance and repurchase volume are just some of the components that are incorporated into deter-
mining the quality of an originator.
9Rating U.S. Retail Auto Loan Securitizations
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DBRS views favorably those originators that have robust guidelines and use reliable means to accu-
rately assess an owner’s income and employment. Furthermore, sophisticated technology and strong
fraud-detection procedures can help prevent early payment defaults as well as accurately determine debt-
to-income and payment-to-income ratios. An originator’s exception and override practices can also help
to assess the quality of the originations. Additionally, separation of the origination and underwriting
functions as well as a compensation structure that emphasizes quality over loan volume can help to ensure
predictable performance.
TECHNOLOGY
Technology resources are an integral component of the originator review process. While DBRS does not
subscribe to specific systems architecture, adequate systems controls, consumer privacy protection and
backup procedures, including disaster recovery and business continuity plans, are considered critical
processes and should be in place. Furthermore, originators must ensure that any offshore vendors are
monitored and a backup plan is in place to ensure minimal downtime.
Over the past few years, leveraging the Internet has enabled many originators to operate effectively in
the auto finance business. Originators may use the Internet for marketing, customer service and the
dissemination of pertinent information, such as applications and approvals. As a result, DBRS expects
originators to have the appropriate staff and controls in place to ensure website availability, account
maintenance and enhancements. Sophisticated technology, with robust functionality, is viewed favorably
by DBRS as it often helps bring large efficiencies to the origination operations in addition to more predict-
ability in terms of loan performance.
SERVICER REVIEW
The servicer review process evaluates the quality of the parties that service and conduct backup servicing
on the loans being securitized. DBRS meets with senior management at the servicing entity to discuss the
servicing operations, tour the facilities and review system demonstrations, as appropriate. DBRS assesses
the information gathered through the review process, along with its surveillance data and industry statis-
tics to determine if a servicer is acceptable. In instances where DBRS determines that the servicer is below
average, issuers may incorporate certain structural enhancements into a proposed transaction, such as
additional credit support, dynamic triggers or the presence of a warm or hot backup servicer, in order for
DBRS to be able to rate the transaction.
The servicer review process typically involves an analysis of the following:
• Company and management,
• Financial condition,
• Dealer management,
• Loan administration,
• Customer service,
• Collections,
• Remarketing/loss mitigation,
• Bankruptcy,
• Investor reporting and
• Technology.
For details on the servicing review process, please refer to the DBRS methodology Operational Risk
Assessment for U.S. ABS Servicers.
10Rating U.S. Retail Auto Loan Securitizations
August 2013
Transaction Structures
TYPES OF TRANSACTIONS
U.S. retail auto loan ABS transactions may be either completed with an amortizing or revolving structure.
In an amortizing transaction, a discrete pool of auto loans backing the transaction is often determined at
closing. Amortization of the collateral provides for the cash flows to pay the bonds and transaction-related
expenses. A revolving transaction allows for loans to be added to the transaction, up to predetermined
limits. Principal collected from the amortization, or pay off of the collateral, is used to fund additional
loans in the revolving structure. A common type of revolving transaction is a warehouse facility, which
is used by an asset originator to fund loans until there is a sufficient volume of loans to complete a term
ABS transaction.
LEGAL CONSIDERATIONS
U.S. retail auto loan ABS transactions have historically been completed using either a grantor trust or an
owner trust structure. Early securitizations utilized a grantor trust structure. The grantor trusts require
distribution of principal and interest collections, after expenses, to be distributed on a pro rata basis,
effectively preventing the cash flow structures from being time tranched by maturity or risk. Most trans-
actions completed today typically utilize owner trust structures. The owner trust structure provides the
ability to re-allocate cash flows among securities within the structure, allowing credit risk to be miti-
gated by utilizing excess cash flows to reduce the balance of the outstanding notes. A common owner
trust structure contains several classes, possibly with both senior and subordinate notes, with differing
expected maturity dates.
Bankruptcy-Remote Special-Purpose Entity
Similar to other structured finance transactions, auto loan securitizations are rated based on the credit
quality of a segregated pool of auto loan receivables in addition to other analytical considerations, as
noted in the Executive Summary section. For a security to achieve a higher rating than that of an entity
completing the securitization, the loans must be isolated from the financial risk of the seller and originator
and beyond the reach of their creditors in the event of a bankruptcy. To accomplish this, the assets must
be transferred to a bankruptcy-remote special-purpose entity (SPE), whereby the assets would not become
part of the bankruptcy estate of the entity completing the securitization or subject to an automatic stay
under the Bankruptcy Code.4
Receivables Transfers
In the analysis of a U.S. retail auto loan ABS transaction, DBRS seeks to ensure that the proper legal steps
have been taken to transfer the receivables and all of an originator’s rights and interest in the auto loans
to the SPE and that the SPE has been granted a security interest in the loans. A Uniform Commercial
Code (UCC) financing statement must be filed to perfect the granting of a security interest from origina-
tor/seller to the SPE, and further financing statements will be filed perfecting the subsequent grant of
a security interest from the SPE to the indenture trustee. DBRS seeks assurance, in the form of a legal
opinion provided by counsel for an originator/seller, that all necessary filings against an originator/seller
have been made, that all necessary steps have been taken and that no subsequent actions are required to
protect the ownership interests of the SPE in the assets.
As the originator generally acts as a servicer of the contracts, the originator/seller in its capacity as
servicer and agent for the SPE issuer may retain the assigned contracts in its possession, provided that
4. The current Bankruptcy Code was enacted in 1978 and became effective on October 1, 1979. The Bankruptcy Abuse
Prevention and Consumer Protection Act of 2005 enacted several significant changes to the Bankruptcy Code. The
most recent changes to the Bankruptcy Code were signed into law on April 20, 2005, and became effective on October
17, 2005.
11Rating U.S. Retail Auto Loan Securitizations
August 2013
each transfer of the contract from the originator and the lien of the indenture trustee is perfected under
the applicable UCC by filing a UCC financing statement in the appropriate jurisdiction. Typically, the con-
tracts are chattel paper under the UCC and, accordingly, there is a risk that were the originator/seller to
sell the contracts, inadvertently or otherwise, to a bona fide third-party purchaser for value without notice
of the previous assignment to the SPE, such purchaser’s interest would take precedence over the interest
of the SPE (and the indenture trustee) in the contracts. DBRS therefore requests that the originator/seller
mark its computer records to show that the contracts have been sold to the SPE and may also request that
the originator/seller take other reasonable steps to clearly identify or physically segregate those contracts
that are assigned to the SPE from all others in its possession. In some cases, or if an event of default has
occurred and is continuing under the transaction documents, the originator/seller may relinquish posses-
sion of the contracts or appoint a custodian to hold the contracts.
Transaction Legal Structure
The legal structure of a U.S. retail auto loan ABS transaction differs depending upon a number of factors.
The first is whether a transaction is a one- or two-tier transfer of assets. This refers to the number of times
the assets are transferred between entities from the entity who had originated or purchased the assets to
the SPE issuer of the debt. In a two-tier transaction there is an intermediate SPE, which is usually the
depositor, who deposits or sells the assets to the issuing SPE and borrows from the issuing SPE.
Transactions may also differ in terms of the parties involved in the transaction and their roles. The fol-
lowing diagram depicts a typical transaction structure for a U.S. retail auto loan ABS transaction. As
delineated, the originator of the assets is also the servicer and receives a servicing fee to service the issuing
entity assets. The issuing entity, in this case, is an owner trust so there is an owner trustee in addition to
an indenture trustee. In certain cases, there may be a back-up servicer, which may also be the trustee. To
mitigate interest rate risk, there may also be an interest rate swap counterparty included in the structure.
Originator
&
Servicer
Transfer of
$
Receivables
Depositor
Sale of $
Indenture
Receivables
Trustee
Interest Rate Swap
Issuing Entity Counterparty
(if necessary)
Owner Trustee
Notes $
Investors
DBRS reviews a transaction’s legal structure to assess that all steps have been taken to insulate the rated
securities from the risk of bankruptcy of the entity completing the securitization. Additionally, for a
description of the legal considerations for structured finance transactions, please refer to the DBRS pub-
lication Legal Criteria for U.S. Structured Finance Transactions.
12Rating U.S. Retail Auto Loan Securitizations
August 2013
ABS Financial Structure
Typical U.S. retail auto ABS transactions utilize a financial structure whereby bondholders receive protec-
tion against pool losses from available credit enhancement and the transaction’s structural features.
TYPES OF CREDIT ENHANCEMENT
The DBRS rating analysis focuses on the assessment of proposed credit enhancement supporting the
debt obligations issued in connection with the transaction. Credit support may be “soft,” which include
enhancements that support the transaction’s obligations, if and when, they are available, or “hard,”
which are enhancements directly available to support the transaction obligations. Typical forms of credit
support in a U.S. retail auto loan ABS transaction include excess spread, amounts on deposit in reserve
accounts, overcollateralization (OC) and subordination.
In certain cases, transactions include Subvented Loans and may incorporate a mechanism, a cash reserve
or another form of enhancement to fund the pool’s shortfall in yield income related to the below-market
rate loans.
DBRS may consider other forms of credit enhancement in its rating analysis. One such credit enhance-
ment, although less common today, is the use of an insurance policy to provide credit support. The
insurance policy may be in the form of a surety bond, which would provide an irrevocable guaranty of the
payment of timely interest and ultimate principal. DBRS assesses the form and sufficiency of a proposed
transaction’s credit enhancement in the rating analysis. The typical forms of enhancements are described
in the following section.
Excess Spread
Excess spread is a form of soft credit enhancement that is created within the transaction. Excess spread is
interest generated by the assets that exceeds the cost of funding on the offered notes. The difference, net
of transaction expenses such as servicing, trustee and professional fees, is commonly referred to as excess
spread and is available on a monthly basis to absorb losses. Any changes in cash flows due to losses are
first covered by excess spread. After all of the obligations prescribed by the transaction structure are satis-
fied, remaining excess collections may be released. Consequently, monthly excess spread is only available
to cover losses incurred during that same period.
Since excess spread is based on anticipated, but uncertain, collateral collections, it is subject to variability
based on the performance of the collateral relating to the underlying obligors failure to pay in a timely
fashion. Consequently, DBRS takes a conservative approach in assessing the value of excess spread for
rated transactions.
Cash Reserve Accounts
A cash reserve account is a form of hard credit enhancement that is available to pay interest, and some-
times principal, on the transaction obligations.5 Reserve accounts are included in most U.S. retail auto
loan ABS transactions and are typically sized as a percentage of the collateral or debt outstanding, and
are funded either at the outset of a transaction or over time through the transaction cash flows. Reserved
amounts provide additional liquidity to the transaction and may be included to allow the transaction to
successfully perform under stressed scenarios or to address transaction-specific risks or current market
conditions. As principal amortizes and seasoning increases, reserve account balances may be permitted to
decline over time.
5. Please refer to DBRS’s Legal Criteria for U.S. Structured Finance Transactions.
13Rating U.S. Retail Auto Loan Securitizations
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Overcollateralization
OC is another form of hard credit enhancement which acts as loss protection, absorbing losses before any
shortfalls are allocated to transaction investors. OC is achieved by the issuance of obligations in a lesser
amount than the value of the collateral securing those obligations. A transaction may have OC at closing
and/or OC may build a pre-specified target level based on amortization of the ABS notes with available
cash flows. OC may be sized as a percent of the initial pool balance or as a percent of outstanding pool
balance, the latter allowing for the release of excess collections if the OC target level has been achieved.
The majority of declining OC structures utilize an overcollateralization floor, which is typically expressed
as a percentage of the initial collateral balance and provides back-ended protection to the issued notes.
Subordination
Subordination is also a form of hard credit enhancement that creates a cushion for losses from the related
collateral. Subordination is created by a more junior class of notes that is subordinate in the right to
receive amounts available for payments. These junior classes are available to absorb losses, and therefore
act as additional support for the more senior classes. DBRS analyzes any mechanisms within a transac-
tion that modify the availability of these junior classes to act as credit support for the more senior classes.
Yield Supplement Account/Yield Supplement Overcollateralization
DBRS assesses the structural mechanics incorporated in the transaction to address the risk associated with
Subvented Loans. Inclusion of Subvented Loans in a collateral pool may result in insufficient interest
earned by the loans to cover transaction costs. In such instances, it is common for transaction struc-
tures to include a yield supplement account (YSA). The YSA is typically a cash reserve account funded
at closing. The amount of cash deposited to the YSA is typically the amount necessary to make up the
difference between the yield of the collateral pool and the amounts necessary to cover all funding costs
through the life of the transaction. The YSA and funds in the YSA are subject to the same investment and
procedural guidelines as other cash reserve accounts.
The yield on a transaction’s collateral pool may also be supplemented via the use of yield supplement
overcollateralization (YSOC). YSOC generates the additional yield for the transaction collateral pool by
the issuance of obligations in a lesser amount than the value of the collateral securing those obligations.
The amount of YSOC is determined by discounting the notional value of assets at a discount rate that
ensures the asset yield is sufficient to cover all funding costs through the life of the transaction. The size of
the YSOC is the difference between the discounted value of assets and their notional amount.
PRIORITY OF PAYMENTS
The priority of cash flow payments for a U.S. retail auto loan ABS transaction depends upon the type
of payment structure employed in that transaction. On a regular basis, collections on the assets are
aggregated and then distributed to noteholders based upon the priority of payments established in the
transaction documents. Collections on the loans may be aggregated in a manner such that principal and
interest collections are combined to create a pool of total available funds that are then subjected to a
payment waterfall. Alternatively, principal and interest collections may be accounted for separately and
then subjected to the payment waterfall.
Once the amount of collections on the loans is determined, the collections pass through a payment water-
fall that allocates collections in descending order of priority. Recurring transaction expense items, like
servicing and trustee or transaction management fees, are commonly senior in the waterfall, after which
noteholders receive interest and principal. The allocation of interest to noteholders is typically sequential.
There are two common methods for allocating principal payments in a transaction structure; sequential
pay and concurrent pay. A sequential pay structure provides for all principal collections to be allocated to
the senior most class, and the shortest maturing class in the case of time tranche senior classes, until it is
paid in full. Once paid, principal collections are then directed to the next most senior class outstanding.
Losses in excess of the available hard credit enhancement are absorbed by the junior most tranche. Once
14Rating U.S. Retail Auto Loan Securitizations
August 2013
the junior most tranche is written down, the losses are absorbed by the second most junior tranche in the
structure. Notes that carry the same rating receive distributions on a pari passu basis, and writedowns
are applied pro rata.
An example of the typical payment priority under a sequential pay structure is as follows:
(1) Servicing fees and any transition fees to any successor servicer up to a specified limit (if applicable);
(2) Trustee and other fees up to a specified limit;
(3) Net swap payment (if applicable);
(4) Interest in order of seniority and swap termination payment (if applicable);6
(5) Principal in order of seniority;
(6) Amount, if necessary, to be deposited into the reserve fund;
(7) Additional amounts owed to the trustee or servicer above the specified limits in 1 and 2 above; and
(8) Any remaining amounts to the entity completing the securitization.
A concurrent pay structure allows for principal collections to be allocated to senior and subordinate
tranches concurrently, based on each respective notes proportionate share of the capital structure.
Concurrent pay structures may include a trigger mechanism that changes allocation of principal in the
event performance deteriorates. If the trigger is breached, the subordinate tranches are typically locked
out and principal collections are allocated to the senior most tranche. Transaction provisions may provide
for a mechanism that allows for trigger breaches to be cured, causing principal payment allocations to
revert back to the original payment priority.
TRANSACTION TRIGGERS
U.S. retail auto ABS transactions may utilize rating thresholds or trigger mechanisms whereby adverse
performance of the underlying collateral results in a change to the initial cash flow structure. Triggers
typically measure collateral performance and are designed as an early warning mechanism, which may
adjust the initial cash flow structure to protect against an erosion of credit support. To the extent a
trigger is breached, the credit enhancement amount may be increased and excess spread may be directed
to increase reserve account balances or available cash flow may be directed to pay down the most senior
bonds outstanding more quickly, increasing the amount of OC. This mechanism ensures the subordinate
bonds remain outstanding longer, therefore continuing to act as credit support to the senior bonds.
Depending upon the structure of a transaction, triggers may be beneficial to increase credit enhancement
levels beyond what is initially included in the transaction, thereby enabling the transaction to absorb
more losses. DBRS does not dictate the transaction triggers to be included in a particular structure;
however, DBRS may assess the extent to which any additional credit enhancement may be built up in a
transaction as part of the overall assessment of the transaction structure and cash flow scenarios. The
extent to which triggers are beneficial in building additional credit enhancement depends upon the level
at which the triggers are set and the ability of the transaction to generate excess spread at those levels.
Meeting this standard also depends upon the potential deterioration in performance of the transaction, as
there will be less excess spread generated if losses increase.
6. In cases where the swap counterparty is the defaulting party, the swap termination payments should be subordinate to
payments of interest and principal on the rated securities.
15Rating U.S. Retail Auto Loan Securitizations
August 2013
PREFUNDING
A prefunding structure occurs in an amortizing transaction when there are more notes issued at closing
than collateral supporting the transaction. To compensate the transaction for the over-issuance, a portion
of the proceeds are placed into an account for the purpose of funding additional loans after closing,
including the amount of interest that would have been earned during the prefunding period. The prefund-
ing period is typically limited to a specified number of months post-closing. During the prefunding period,
loans are sold to the transaction issuing entity in exchange for the funds in the prefunding account. Any
funds not used to acquire loans are applied to repay the notes. In addition, there are specific requirements
provided in the transaction documents that must be met in order for the loans to be considered eligible for
the transaction. The eligibility criteria are typically designed to ensure that the pool of subsequent receiv-
ables is similar to the original pool of receivables at closing. DBRS assesses the terms of the prefunding
for acceptability in the context of assigning ratings.
LEGAL FINAL MATURITY DATES
The legal final maturity date for a security is the last possible date that a security could be paid off in full.
The legal final maturity date determination must consider all scenarios that could extend the maturity of
a security. The considerations include payment deferrals, extensions, legal delays and other considerations
that could potentially delay receipt of receivable payments and maturity dates. Generally, the legal final
maturity date for the last maturing security is the latest scheduled maturity date of the longest maturing
loan in the securitized pool plus at least six months.
Money Market Tranches
U.S. retail auto ABS transactions commonly include the issuance of a money market tranche, eligible
under Rule 2a-7 of the Investment Company Act of 1940. Under Rule 2a-7, the money market tranche
should have a maximum maturity not to exceed approximately 13 months (397 days or less). DBRS cash
flow analysis demonstrates that the money market tranche pays off in the required time period assuming
a 0.5% absolute prepayment speed and no losses.
16Rating U.S. Retail Auto Loan Securitizations
August 2013
Collateral Quality
As part of the analysis of the transaction, DBRS analyzes the characteristics of the proposed underlying
collateral pool to assess the probability of default and loss severity expectation. In addition, as warranted,
DBRS assesses the collateral pool statistics against the eligibility criteria set forth in the transaction legal
documents. This step serves to ensure that prescribed limits of certain collateral types are reflected in the
analysis.
POOL CHARACTERISTICS
When rating a transaction backed by a pool of auto loans, DBRS typically receives pool stratifications
that provide a summary of the pool’s characteristics, such as information related to vehicles, loan terms
and certain obligor information. Generally, the characteristics of the underlying loans that comprise the
proposed collateral pool should mirror the static pool loss performance provided by the sponsoring
company as closely as possible. However, DBRS recognizes that pools with similar summary characteris-
tics can demonstrate significantly different performance. For instance, two portfolios may have identical
remaining terms to maturity, but the underlying stratifications may indicate that one pool has a greater
preponderance of longer-term loans that are likely to have a higher loss profile. For this reason, it is
important that sponsors have the reporting capability to provide static pool performance data that can
be stratified by attributes, such as credit score, loan term or other relevant attributes necessary to assess
a proposed pool’s risk of loss. In cases where sufficient loss performance detail has been provided, DBRS
can refine its loss analysis by using the data to determine a loss estimate for each distinct component of
the pool and then use this information to develop a weighted-average loss expectation for the securitized
pool based upon the relative contribution of each segment.
DBRS develops an expected loss (also referred to as a base case loss expectation) for each auto loan pool.
DBRS analyzes originator-specific performance history and pool-specific characteristics provided by an
originator and may also review the originator’s managed portfolio loss or look to compare the origina-
tor’s experience to the performance of other originators within the auto finance market. DBRS utilizes
this historical information to help assess future pool performance. Preferably, DBRS expects sponsors
to provide loss information, as described below, that covers asset performance during various economic
cycles. This enables DBRS to evaluate the impact that macroeconomic factors, such as unemployment
levels, may have on collateral performance.
STATIC POOL DATA
DBRS uses a static pool approach to develop an expected loss assumption for a transaction. Static pool
analysis relies on historical loss data from discrete groups of loans originated over a relatively short
period of time; ideally, these time periods should be monthly or quarterly, as annual vintage data may lack
the precision to assess performance volatility during periods of economic stress. In this analysis, a ratio of
losses to original loan balance is tracked on a monthly basis for a static pool of assets as they amortize.
If the collateral composition is similar, static pool analysis is an effective tool for establishing loss expec-
tations because, all else being equal, two pools of assets that have similar collateral composition during
similar economic environments can be expected to have similar losses over their lives.
DBRS seeks to receive historical data with sufficient granularity across the key risk components of the
pool. Sufficient granularity may include defining appropriate stratifications or pooling data by cohort
relevance. While aggregate pool characteristics may differ by transaction, sub-pools within the aggregate
pool will likely share characteristics that aid in the determination of expected losses. DBRS may request
an originator to segregate historical static pool performance data and the proposed securitization pool
into sub-pools of common collateral characteristics. In cases where sufficient performance detail has been
provided, DBRS can refine its loss analysis by using the data to determine a loss expectation for each
17Rating U.S. Retail Auto Loan Securitizations
August 2013
distinct sub-pool, then uses this information to develop a weighted-average loss expectation for the secu-
ritized pool based upon the relative contribution of each sub-pool.
The static pool data should be presented such that loans are considered defaulted in a manner that is
consistent with the definition of a defaulted loan in the transaction documents to ensure that cash flow
stresses are constructed in a manner that properly addresses the collateral’s loss profile.
DBRS typically receives at least three years of performance history from an originator to perform its
rating analysis. In the absence of adequate performance history, DBRS may decline to rate the transaction
due to the insufficiency of the provided data. For cases where static pool loss data is insufficient, DBRS
may consider using other methods in developing an expected loss. DBRS may assess the loss history for
the managed portfolio of the originator or use industry comparable loss data as a proxy.
While using managed portfolio statistics as a method to develop an expected loss, this approach has
shortcomings. Portfolio figures are biased downward during periods of portfolio growth. While it is
possible to make adjustments to the data to address this phenomenon, these adjustments do not provide
insight into the timing of losses, an important component of DBRS loss analysis used in transaction cash
flow modeling. In addition, utilizing portfolio figures makes it difficult to adjust for changes in asset com-
position. As a result, in the absence of static pool data, DBRS requests supplemental data to help refine
its loss projection.
In the event that DBRS utilizes managed portfolio statistics or proxy data, DBRS typically reaches a
higher expected loss projection than would otherwise be the case.
Recoveries
The recovery rate of a defaulted loan refers to the amount received upon the liquidation of a vehicle after
considering all costs associated with the repossession, remarketing and liquidation of a vehicle. Recovery
rates are typically measured as a percentage of the loan amount at the time of default. Deficiency balances
may be pursued by a lender after a vehicle has been liquidated.
Recovery rates can vary among pools of auto loans with very similar characteristics, as they tend to be
susceptible to changes in market conditions and servicing practices. In addition, supply and demand
imbalances in the used vehicle wholesale market, gasoline prices and manufacturers’ financial strength all
impact recovery values on liquidated receivables.
DBRS requests and typically examines historical data on an originator’s recovery performance. DBRS
reviews the presented data to determine the sources, stability and continuity of data and the resulting
recoveries. Due to the volatile nature of recoveries, DBRS typically uses a conservative approach to esti-
mating the expected average recovery rate during the life of a transaction. Even in the event that historical
trends are strong, DBRS may assume a conservative recovery rate assumption to account for possible
changes in market conditions that may occur during the life of a transaction’s cash flows.
Projecting Expected Losses
DBRS analyzes the data provided by the originator in its development of an expected loss. DBRS assesses
the collateral statistics for the historical static pools versus the collateral pool to be included in the trans-
action. As part of the analysis, DBRS assesses the degree to which the historical data is relevant as a
performance indicator for the transaction pool. If the collateral parameters are considered to be similar,
DBRS uses the information to project expected losses. In the event that the provided static pool informa-
tion does not contain a curve or curves that have fully experienced 100% of losses, DBRS may use an
industry comparable or an average of industry wide data or other forecasting methods, as applicable.
18Rating U.S. Retail Auto Loan Securitizations
August 2013
In the case where the auto finance company’s data is sufficient to demonstrate losses on similar collateral
over its lifetime, DBRS constructs a timing curve representing the distribution of periodic losses over
the life of the collateral (Loss Amortization Vector). To accomplish this, DBRS calculates the average
incremental increase in losses on a month-over-month basis for all of the provided vintages. The average
increase in losses on a month-over-month basis is then used to calculate the monthly cumulative loss rate.
The percentage rate of change is calculated for each month, collectively resulting in the Loss Amortization
Vector. The table below provides an example of the construction of a Loss Amortization Vector.
Static Pool Loss Curves Change in Monthly Losses
Cumulative
Median Median Loss
Monthly Monthly Amortization
Period Vintage 1 Vintage 2 Vintage 3 Vintage 4 Vintage 1 Vintage 2 Vintage 3 Vintage 4 Change Change Vector
1 0.00% 0.00% 0.00% 0.00% 0.00%
2 0.08% 0.00% 0.02% 0.00% 0.08% 0.00% 0.02% 0.00% 0.02% 0.02% 0.68%
3 0.19% 0.20% 0.18% 0.13% 0.12% 0.20% 0.16% 0.13% 0.15% 0.18% 4.90%
4 0.31% 0.31% 0.29% 0.21% 0.11% 0.12% 0.11% 0.08% 0.11% 0.28% 7.83%
5 0.42% 0.43% 0.40% 0.29% 0.12% 0.12% 0.11% 0.08% 0.11% 0.39% 10.78%
6 0.54% 0.55% 0.51% 0.37% 0.12% 0.12% 0.11% 0.08% 0.10% 0.49% 13.68%
7 0.65% 0.66% 0.62% 0.45% 0.12% 0.12% 0.11% 0.08% 0.11% 0.60% 16.62%
8 0.79% 0.80% 0.75% 0.54% 0.14% 0.14% 0.13% 0.09% 0.12% 0.72% 20.06%
9 0.92% 0.94% 0.88% 0.64% 0.13% 0.14% 0.13% 0.09% 0.12% 0.84% 23.46%
10 1.03% 1.05% 0.99% 0.72% 0.12% 0.12% 0.11% 0.08% 0.11% 0.95% 26.41%
… … … … … … … … … … … …
64 3.56% 3.63% 3.40% 2.47% 0.03% 0.03% 0.03% 0.02% 0.03% 3.34% 93.28%
65 3.59% 3.66% 3.43% 2.49% 0.03% 0.03% 0.03% 0.02% 0.03% 3.37% 94.03%
66 3.62% 3.69% 3.46% 2.51% 0.03% 0.03% 0.03% 0.02% 0.03% 3.40% 94.82%
67 3.66% 3.73% 3.49% 2.53% 0.04% 0.04% 0.03% 0.02% 0.03% 3.43% 95.69%
68 3.69% 3.76% 3.52% 2.56% 0.03% 0.03% 0.03% 0.03% 0.03% 3.46% 96.56%
69 3.73% 3.80% 3.56% 2.58% 0.03% 0.04% 0.03% 0.02% 0.03% 3.49% 97.44%
70 3.76% 3.83% 3.59% 2.60% 0.03% 0.03% 0.03% 0.02% 0.03% 3.52% 98.24%
71 3.79% 3.87% 3.62% 2.63% 0.04% 0.03% 0.03% 0.02% 0.03% 3.55% 99.11%
72 3.83% 3.90% 3.65% 2.65% 0.03% 0.04% 0.03% 0.02% 0.03% 3.58% 100.00%
The Loss Amortization Vector is used to project the expected loss for any pool vintages that have not
experienced 100% of their losses. This projection allows DBRS to compare the expected loss for pools
that have not experienced their complete loss cycle with those that have. As an example, for a static pool
with 65 months of performance history and a term to maturity of 72 months, there are seven months of
losses still to be incurred. Utilizing the Loss Amortization Vector, the pool has experienced 94.03% of its
losses by month 65. DBRS projects the total expected loss by dividing the losses experienced at month 65
by 94.03% and then multiplying that amount by the figure of losses expected in that month on the Loss
Amortization Vector.
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