News Analysis
Pre-emptive lawsuits envisaged
The threat of significant losses has sparked concern that the US subprime auto ABS sector could see pre-emptive legal actions emerging. With spreads continuing to tighten in the face of increasing delinquencies, investors may start to question whether they are being adequately compensated for the risks involved.
Joe Cioffi, partner at Davis and Gilbert, says that while losses in subprime auto ABS have yet to "flow through to investors", they may start to look more closely at these transactions and ask whether they are appropriately priced for the risks involved. As such, he suggests that investors are starting to develop a "growing feeling that something is not right."
Given this growing concern, the potential for legal action could arise in the event that auto deals start to see losses. Investors may also wish to avoid the delays associated with the subprime mortgage crisis, after which participants sometimes waited several years to launch legal action.
Cioffi says: "Trustees may be much more inclined to act, and investors may also encourage trustees to act faster than in the case of subprime RMBS. Trustees may consider taking legal action against sponsors and depositors to pre-empt suits against them by investors, because investors may try to claim they are being exposed to a material increased risk of loss as losses are incurred by the trust itself, even if credit enhancements are providing investors with a cushion."
Consequently, trustees may start changing their behaviour to highlight that they are performing their duties and also "taking discretionary action where warranted for the benefit of investors", as well as cooperating with them. They may want to show, Cioffi suggests, that they are not just relying on the cushion of credit enhancement.
In particular, comments Cioffi, trustees in subprime auto ABS transactions may be asking themselves if they want to be questioned in future about "why they took no action if they have reason to suspect any of the issues that have been reported in certain instances - issues such as dealer fraud, low incidence of income verification or dealer fraud, low incidence of income verification or missing documentation - are present in their deals. They could ask these questions now or they could be asked by investors in lawsuits."
Along with rising delinquencies, auto debt's status as consumers' priority payment may also be threatened, posing further risks to the sector. Cioffi comments that this could result from a range of factors, including the rise of alternatives to car ownership - such as car-sharing services - as well as generational shifts that now see "a quarter of high school students graduate without a license to drive."
As a result, he notes: "If subprime borrowers get behind in their car payments, it may be more convenient for them to let the car go and find another way to work."
Wells Fargo structured products analysts agree that caution is warranted until the market takes account of these risks and suggest that investors may want to move up in credit or temporarily slow purchases of new bonds. Furthermore, they indicate that a material risk of legal action could harm bondholders in the near term through increased headline risk and wider spreads.
Nevertheless, the analysts comment that lower FICO and higher WAC subprime auto ABS pools are exhibiting "relatively stable" cumulative net loss rates, suggesting credit trends are relatively stable and close to market expectations. They add that so far the subprime auto ABS sector is adequately enhanced to account for the current credit and market risks.
While uncertainty persists around the rise of delinquencies in the subprime auto ABS market, opportunists are making preparations to capitalise on potential disruption. Cioffi concludes: "There are some investors known to be considering funds to invest in distressed subprime auto ABS."
03/11/2017 14:05:34
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