Recently, Dechert Partner Sarah Milam partook in an auto ABS panel discussion at ABS East in Miami, Florida. Sarah and four distinguished panelists discussed the state of the ABS auto loan market, issuance, yields, collateral performance, ESG trends, and deal structures. Sarah sat down with Associate Griffin Hamilton to recap the conference.
Griffin: How was ABS East?
Sarah: ABS East was great! People seemed to be in generally good spirits and not as gloomy as I’ve heard about some of the other conferences. People are still issuing, people are still doing deals, people are finding new ways to do deals and, generally speaking, finding ways to adjust to the volatility of the market and the difficult interest rate environment.
Griffin: Sentiment among attendees and presenters was good? Hungry for innovation?
Sarah: Yeah, I think that everybody is obviously concerned about what the near future brings and what appears is certainly going to be a downturn. It is already proving to be a challenging interest rate environment, but asset backed securitization, as we know from the previous crisis, is less cyclical than other areas. Originators are looking toward the future and ways they can finance. There has been some expansion in private investment and non-traditional securitization structures. A good portion of ABS securitization has moved into the 144A market; all these factors, I think, contribute to more optimism than some other sectors.
Griffin: Despite volatility in the markets, ABS issuance overall, not necessarily auto ABS, is maintaining pace with 2021 issuance, a post-crisis record year. Why do you think ABS is out-pacing other bonds? Is auto ABS holding up as well as other asset classes?
Sarah: Generally speaking, what we consider ABS: auto, consumer, credit card, just hasn’t taken as much of a hit. We are starting to see higher delinquencies in auto, moving towards pre-pandemic levels, but it is only beginning to translate into losses. As is in the case of our broad asset classes, we really benefited a lot from a strong first quarter, so that’s really a continuation on from 2021. I think a big concern is what the fourth quarter will bring. Traditionally Q4 has been such a strong quarter. This year it’s looking like it may not be that way, as deal flow has slowed. That being said, there’s a lot of issuers who need to issue; they have assets and they need to put them somewhere. They need to continue to securitize to fund their business, and auto in particular. It has been a very strong auto market in a lot of ways. So, I really think the headline is that 2022 has kept on pace, but there is a lot of concern about the fourth quarter, and I think everyone is generally in agreement that it is likely things will fall off at some point. So, in some ways, people are just trying to move along transactions now before that happens.
Griffin: Do you think another reason ABS is holding up better than other securitization is that the consumer is relatively strong?
Sarah: Consumers are still purchasing. We are going to get to a point where people are not purchasing. We are just starting to see delinquencies, but with the strong job market, etc. we haven’t gotten to the point where it’s showing up in losses. As consumer health and employment changes, it will happen.
Griffin: With the relatively short maturity of auto loans, is auto ABS a good hedge against elevated interest rates?
Sarah: A lot of people do think there is a lot of opportunity in the riskier side of transactions, like non-investment grade, due to the high returns. Those who think the rhetoric around interest rates is over-hyped see a lot of opportunity in sub-investment grade. Initial Purchasers are requiring increased overcollateralization and reserves in new issuances.
Griffin: How is the financial climate affecting spreads and pricing?
Sarah: It is wild. The difference between last year and this year is nuts. The same issuer, the same type of asset pool, and it’s like night and day. Deals are still getting done because people have assets to sell. I think you are going to start to see people move away from straight securitization and 144A deals because there is going to be more attractive sources of capital—through whole loan sales, forward flow sales, particularly by private debt purchasers. I think private debt will be on the forefront once things shake out. There will be investors that continue to find these assets attractive. Private capital and alternative transaction structures has been the story for a while, and I think this trend will accelerate during the downturn.
Griffin: COVID-19 resulted in global supply chain strains and an influx of consumer cash, which drove up demand for new cars and especially for used cars. More recently, supply chain pressures are starting to subside, the used cars market is cooling, interest rates are high, and consumers are tighter on cash. How is that affecting demand, new issuance, collateral performance, and deal structure?
Sarah: Delinquencies dropped dramatically during COVID. Money was flowing into the economy, interest rates were low, people were not buying and selling their cars because they couldn’t. We are seeing that normalize and get back to pre-pandemic levels. Prime is holding up pretty well. Subprime a little less so, but that is just what you would expect. This has not been a normal time as far as losses go.
It is concerning that delinquencies have gotten back to pre-pandemic levels so quickly. I guess the big question is when do delinquencies rise above pre-pandemic levels and how will that affect things. The question remains: what happens when some of these consumer issues start hitting? Particularly with subprime. Depending what happens with employment and the supply chain—a lot of different factors. Subprime will always carry heavier losses than prime.
We also have to consider what happens as used car prices drop, supply of new cars increases, and interest rates continue to rise.
Griffin: Switching gears, electric vehicles are becoming a bigger part of the conversation each day. Do you see increased ESG prominence in the sector stemming from the push toward electrification?
Sarah: I do see increased interest in ESG. There is not much of a difference showing in spreads or pricing for ESG bonds, yet, and I think this is partially driven by the fact that there is little consensus about what exactly qualifies for ESG. As opposed to Europe, the U.S. lacks strong guidelines about what qualifies as a green bond and there are still questions about greenwashing. We haven’t gotten to a point where we have a good, strong set of principles to guide ESG investing. We are going to see that develop over time. I think we are getting close to a tipping point, as the conversation is there, and people are coming together to form a consensus on what can qualify. Investment managers are raising funds that have ESG directives and are going to need ESG investments—one of the ways to do that is through auto. There is still a lot to evaluate even with green vehicles when it comes to whether something should or does qualify under ESG principles. Also, the SEC is increasingly focused on ESG-related disclosure. Initially, that focus has been on investment funds, but the expectation is that it will trickle down to ESG bonds as well.
Griffin: How is ABS competing against whole loan sales as a form of funding for issuers?
Sarah: We have seen issuers become more interested in whole loan sales. Some issuers have decreased the size of their ABS offerings in order to sell whole loans. I think this can partially be attributed to private funding and investors that are able to purchase. There’s more investors and structures outside of plain vanilla 144A term securitizations than there have been in the past. It’s just that people have found other, more creative, ways to do things. 144A deals will always be there, but people will continue to innovate.
Griffin: What are some trends you expect to see continue, or new ones you think might pop up, in 2023? Changes in deal structure in the volatile market?
Sarah: We’ve seen variable reserve accounts to compensate for variations in pricing and flexibility in other areas and structures to address volatility, and, again, increasing overcollateralization requirements to absorb expected losses. There’s been a lot of stop and go in a lot of transactions just because of how volatile the market has been.
Griffin: Thank you for your time, Sarah. I’m glad to hear your panel at ABS East was a success and the industry is excited to continue evolving.
Sarah: Thank you, Griffin.