Methodology
Dominion
Bond
Rating
Service
DBRS Rating
Criteria - U.S. Auto
Asset-Backed
Securities: Net
Interest Margin
Securities (NIMs)
DECEMBER 2005
MARC DALY
SHARON MCGARVEY, CFA, CPA
DBRS Rating Criteria – U.S. Auto Asset-Backed Securities: Net Interest Margin Securities (NIMs)
EXECUTIVE SUMMARY
This methodology describes DBRS’s approach to rating
auto NIMs (“Net Interest Margin Securities”). Auto NIMs
are certificated securities where the holder has a claim on
the transaction’s residual cash flow. NIM technology first
emerged in the public mortgage market in 1987. After
substantial growth in issuance, NIMs are now an established
sub-sector of the mortgage market.
Like mortgage NIMs, auto NIMs involve securitizing the
net interest proceeds (also known as excess spread) or
residual cash flow that remains in a transaction after:
(1) paying interest on the underlying ABS securities;
(2) paying the trustee, servicer, and other expenses; and
(3) absorbing collateral losses.
Similar to mortgage NIMs, auto NIMs enable issuers to
monetize residual cash flow upfront.
As with other auto ABS transactions, the key assumptions
that impact a NIM rating are: (1) the credit quality of the
collateral pool and the corresponding expected loss levels,
(2) the timing of expected losses, (3) prepayment speeds,
and (4) interest rate stress scenarios.
OVERVIEW OF AUTO NIMS
What is a NIM?
A NIM is essentially an Interest Only (“IO”) strip, with its
cash flow derived from a transaction’s net interest proceeds.
A NIM principal balance is created by discounting the net
interest proceeds, or excess spread, at a risk-adjusted rate. In
structuring a NIM, stressed residual cash flows are recharacterized into components that pay both principal and
interest to the NIM holder.
Structural Nuances of Auto NIMs
In many mortgage NIM transactions, the issuer posts the
required collateral upfront; therefore, the targeted
overcollateralization (“OC”) for the transaction is fully
funded at deal inception. This feature reduces structural
risk: excess spread from the mortgage collateral is
immediately available to amortize the NIM and need not be
re-directed to build OC.
Typically, auto ABS transactions are structured such that
excess spread is used to absorb pool losses and to build OC
(or reserve accounts) to their required levels before it can be
released to the transaction’s residual or NIM holder. As
excess spread may not be immediately available to amortize
an auto NIM, DBRS may request that auto issuers:
• Include an interest reserve fund account: For
transactions where the OC is not funded upfront,
DBRS, under certain circumstances, may require a
reserve account. The purpose of the reserve fund is to
provide greater assurance of timely principal and
interest payments to the NIM holder.
• Limit the maturity of the NIM: DBRS may require that
the NIM maturity be limited to a certain time frame.
This would enable the NIM holder to receive a majority
of its cash flow sooner, before the transaction has hit its
peak loss period.
Auto
•
Adjust the size of the NIM balance: DBRS may
determine that under certain circumstances a reduction
in the size of the proposed NIM balance may be
warranted.
What Motivates NIM Issuers and Investors?
The auto ABS sector can be broken into two core subsectors: prime and subprime. The prime sector consists of
high-quality receivables, originated primarily by the auto
captive finance companies. Historically, credit losses have
been low on prime pools; therefore, these loans command
lower coupons. In prime ABS transactions, subordination
serves as the primary source of credit enhancement.
Although excess spread levels are lower in these
transactions, prime issuers can still benefit from issuing
NIMs. NIMs enable issuers to monetize residual cash flows
upfront which can generate additional liquidity for their
balance sheets.
Collateral in the subprime sector is originated primarily by
specialty finance companies and regional banks. Given the
higher loss levels and lower borrower credit quality
associated with subprime loans, these loans have higher
coupons than their prime counterparts. Therefore, auto loan
transactions collateralized by subprime pools typically have
higher levels of excess spread than transactions
collateralized by prime loans. In fact, excess spread
comprises a relatively larger component of credit
enhancement for subprime transactions than for prime
transactions. Consequently, NIMs may lend themselves
more easily to the subprime sector. Within the mortgage
market, subprime NIM transactions are more commonplace
than prime NIM transactions.
DOMINION BOND RATING SERVICE
Information comes from sources believed to be reliable, but we cannot guarantee that it, or opinions in this Methodology, are complete or accurate. This
Methodology is not to be construed as an offering of any securities, and it may not be reproduced without our consent.
DBRS Rating Criteria – U.S. Auto Asset-Backed Securities: Net Interest Margin Securities (NIMs) - Page 2
RATING CRITERIA COMPONENTS – NIMS
I. COLLATERAL POOL LOSS EXPECTATION
As with all auto ABS transactions, establishing an expected
net loss valuation for the loan collateral pool is crucial in
determining both credit enhancement and bond ratings.
Since an auto NIM is simply a securitization of a residual
cash flow from an auto loan pool, it is subject to the same
base case collateral loss assumption used to rate the other,
more senior tranches in the securitization. Stress factors are
then applied to the base case loss assumption based on the
desired rating for the NIM.
The key factors impacting expected losses on auto loan
collateral pools are summarized below, while Appendix A
provides further details on how these factors are analyzed
and assessed within the DBRS ratings process.
Borrower
characteristics:
Specific
borrower
characteristics, such as credit score and debt-to-income
ratios, directly correlate to loan default frequency.
Borrowers with lower credit scores tend to default at higher
rates. DBRS uses a granular approach to determine default
frequencies based on borrower characteristics.
Loss severities: Auto vehicle recoveries are directly
correlated to used-vehicle supply and demand dynamics. In
a weaker economy, demand for new cars tends to decline,
which supports used-vehicle prices except in a severe
economic downturn. Conversely, as the economy
strengthens, demand for used vehicles decreases, weakening
vehicle recovery values. Additionally, manufacturer
incentive programs can impact the supply of used vehicles
to the marketplace. New-vehicle incentive programs that
cause excessive trade-ins can result in an oversupply of used
vehicles. The effect of this used-vehicle market
disequilibrium is lower used-vehicle recovery values and,
therefore, higher loan loss severities.
Loan characteristics: Specific loan characteristics, such as
loan seasoning, loan-to-value ratio (“LTV”), and loan term
affect both default frequency and loss severity. Highly
seasoned loans tend to have a lower default risk than newly
originated loans. Higher LTVs correlate with both higher
default risk (greater borrower leverage) and higher loss
severity, particularly when higher LTV loans are longer
term (greater than 60 months). This higher loss severity
occurs because principal amortization is “stretched” out
farther on a longer term loan. Since an auto is a depreciating
asset, this exacerbates the time that it takes for a borrower to
build an “equity” position (current value of the vehicle less
the loan balance) in the vehicle.
Originator underwriting: Poor and inconsistent
underwriting standards cause a higher frequency of defaults.
Firms that have decentralized underwriting procedures
require a more careful analysis to ensure adherence to firm
underwriting guidelines.
Servicer quality: The ability of the servicer to minimize
loan defaults and delinquencies while maximizing collateral
liquidation values is crucial to a pool’s loss performance.
Servicers must possess adequate financial resources to
remain current with technology and to maintain strong
operational practices. While servicers who have experienced
financial difficulty in the industry are a limited set,
collateral deterioration has often been accompanied by
servicer difficulties.
Historical analysis: To assist in projecting expected
cumulative losses, DBRS reviews static pool loss data from
an originator’s portfolio. Static pool data best reflects an
originator’s net loss performance, since the use of portfolio
data will dilute loss ratios during periods of rapid portfolio
growth. DBRS looks for a minimum of three to five years of
historic data. More extensive historical data allows DBRS to
better assess collateral trends and performance.
DBRS Rating Criteria – U.S. Auto Asset-Backed Securities: Net Interest Margin Securities (NIMs) - Page 3
II. LOSS TIMING CURVE
As a residual cash flow or first loss piece, an auto NIM’s
performance will be highly sensitive to the timing of actual
collateral losses. To the extent that collateral losses occur
early in the life of a transaction (more front-loaded), excess
spread will be used to offset losses before any payments are
made to the NIM holder. Therefore, high upfront losses in a
transaction will adversely impact NIM cash flows.
Conversely, if losses occur later in a transaction’s life, auto
NIM cash flows are less impacted because: (1) OC or
reserve accounts typically funded from excess spread may
have reached their required amounts, providing more credit
support to the NIM holder, and (2) a NIM’s expected
average life is much shorter than the average life of the
collateral pool.
In order to address the risk that losses may occur more
rapidly in the early stages of a transaction’s life, DBRS uses
a stressed, front-loaded loss timing curve. DBRS created a
conservative, loss timing base curve using historical data on
various issuers. The analysis reviewed the actual timing of
issuers’ portfolio losses over several vintages as well as
credit tiers, from prime to subprime. DBRS’s loss curve is
presented in Exhibit I below and reflects the following key
features:
•
•
•
The loss curve spans four years,
Losses are concentrated between months 12 and 24, and
Losses are front-loaded, peaking just after the end of
the first year.
Exhibit I
Loss Timing Curve
4.0000%
3.5000%
Period % of Loss
3.0000%
2.5000%
2.0000%
1.5000%
1.0000%
0.5000%
0.0000%
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41 43 45
Months from Origination
DBRS will use this loss-timing curve as the base reference
curve for all auto loan transaction, including NIMs. As with
other transactions, DBRS will determine whether
adjustments to the curve may be necessary to properly
reflect an issuer’s pool characteristics and loss timing
patterns.
DBRS Rating Criteria – U.S. Auto Asset-Backed Securities: Net Interest Margin Securities (NIMs) - Page 4
III. PREPAYMENTS
Prepayments (“prepays”) occur when loans are paid off
before their scheduled maturities. Prepayments are either
voluntary or involuntary—occurring when a borrower
defaults and the vehicle is liquidated, with proceeds
remitted to the transaction. Prepayment speed measures the
rate at which prepayments occur within auto ABS
transactions. In an auto securitization, prepayments reduce
the dollar amount of excess cash flow available to a residual
or a NIM holder. Thus, if prepays occur at a higher rate than
expected, payments to a NIM holder may be impaired.
Relative to the mortgage sector, prepayment speeds in the
auto sector are less volatile. Voluntary prepays are generally
independent of interest rate movements as most borrowers
do not refinance their auto loans. Prepay speeds may slow
during a weak economy as borrowers defer their purchase of
new vehicles. However, prepay speeds may increase as a
loan ages, due to a rise in a borrower’s equity in a vehicle or
in response to aggressive manufacturer incentive programs.
DBRS uses a base case auto prepayment curve for all auto
transactions, including NIMs. From this base case curve,
DBRS then applies stressed payment vectors based on
tranche rating. DBRS developed its base curve by reviewing
voluntary prepayment performance over the past five years
from issuers’ portfolios—from prime through subprime. To
be conservative, DBRS stressed the base case voluntary
prepayment vector to ensure that auto transactions,
including NIMs, can withstand faster than historical speeds.
The base case, BBB, and AAA prepay curves are indicated
below in Exhibit II. DBRS will determine whether
additional adjustments to the curve may be necessary to
properly reflect an issuer’s specific prepay performance.
Exhibit II
Prepayment Vectors
1.95%
Voluntary ABS Speed
1.85%
1.75%
1.65%
1.55%
1.45%
1.35%
1.25%
AAA Vector
1.15%
BBB Vector
1.05%
Base Vector
0.95%
0.85%
1
3
5
7
9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41 43 45 47
Period
IV. INTEREST RATE RISK
Auto ABS transactions are typically “naturally” hedged as
both the collateral and bonds are generally fixed-rate.
However, occasionally, auto ABS transactions include the
issuance of a floating rate tranche that is backed by fixedrate collateral, creating interest rate risk for the transaction.
In a rising interest rate environment, excess spread will
decrease; interest payments on the floating rate bonds will
increase as interest rates rise while collateral coupons
remain fixed. The reduction in excess spread from interest
rate movements may adversely affect the performance of a
NIM issued in connection with the transaction. Therefore,
DBRS evaluates the impact of interest rate risk and basis
risk mismatch on an auto transaction’s cash flow criteria
similar to the analytics applied to evaluating these risks in
mortgage transactions. See Appendix B for further details
on the DBRS process to analyze and stress transactions for
interest rate risk and basis risk mismatch.
DBRS Rating Criteria – U.S. Auto Asset-Backed Securities: Net Interest Margin Securities (NIMs) - Page 5
V. OTHER
Seasoned Pools
The DBRS loss timing and prepayment assumptions may be
adjusted based on the seasoning of the underlying collateral.
To reflect the impact of seasoning on these pools,
prepayments and loss timing assumptions will be modeled
using points further out on these curves. That
notwithstanding, DBRS assumes that the expected loss for
the collateral pool will be allocated over the remaining term
of the underlying transaction.
Transaction Triggers
As part of its analysis of an auto NIM transaction, DBRS
performs its standard review of the underlying
securitization, including the impact of any triggers on the
re-direction of excess spread, and if it is already closed,
current pool performance. As an example, DBRS reviews
whether the underlying transaction relies more heavily on
OC or excess spread, and whether the OC has been
sufficiently eroded to pose a risk to the consistency of the
excess cash flow. DBRS reviews a transaction’s payment
waterfall and structural features to ensure an acceptable
flow of funds to the NIM holder.
Servicer
Due to the leveraged nature of the NIM security as a firstloss piece, the NIM holder is more dependent upon the
servicer’s performance than other investors in the
transaction.
As an example, the amount of loan modifications and
extensions that servicers permit may reduce and delay cash
flows to the transaction—if repossession is ultimately the
only remedy for delinquencies. However, to the extent that
loan modifications and extensions actually reduce defaults,
cash flows to the transaction may be maximized by
following such a servicing strategy. In order to assess the
servicer’s capabilities and related impact on NIM cash
flows, DBRS reviews the servicer’s collection, loss
mitigation, loss severity rates, and repossession procedures,
as well as the servicer’s overall efficiency and operational
strength.
CONCLUSION
DBRS considers many factors when analyzing auto NIM
securitizations. The primary rating factors are the absolute
level and timing of net losses, prepayment speeds, and
interest rate stresses. DBRS relies upon its existing auto
securitization criteria (see Appendix A) as the basis of its
rating criteria for auto NIM transactions. DBRS will
continue to update this methodology as market conditions
deem necessary.
DBRS Rating Criteria – U.S. Auto Asset-Backed Securities: Net Interest Margin Securities (NIMs) - Page 6
APPENDIX A
DBRS’s rating criteria for auto loan transactions are
summarized in the following reports: “DBRS Rating
Criteria for Auto Loan-Backed Transactions,” dated June
2, 2004, and “Update – U.S. Auto Loan Rating Criteria –
December 2005.” These reports, when combined, constitute
DBRS’s most current criteria for rating U.S. auto loan
transactions and address key factors and assumptions in the
rating process, including:
•
•
•
•
•
•
Evaluation of vehicle recovery values and recovery
rates used in the analysis,
Determination of base case expected loss levels,
Allocation of the timing of losses,
Prepayment assumptions,
Impact of servicing on ratings analysis, and
Assessment of an issuer’s loan program, including
origination guidelines.
DBRS Rating Criteria U.S. Auto Asset-Backed Securities: Net Interest Margin Securities (NIMs) - Page 7
APPENDIX B
DBRS evaluates the impact of interest rate mismatch risk
and basis risk on an auto transaction’s cash flow using
criteria similar to those applied to evaluate these risks in
mortgage NIM transactions. Page two of the report, “DBRS
Rating Methodology for U.S. Residential MortgageBacked Securities: Net Interest Margin Securitizations –
July 2005,” discusses the process DBRS uses to evaluate
interest rate mismatch risk and basis risk.