This European auto asset-backed securities (ABS) primer provides a comprehensive guide to the fundamentals and risks of the market and summarizes the latest market developments. We also include an overview of both loan and lease products and present specific jurisdictional characteristics.

Market Overview: Germany And The U.K. Dominate

ABS securitizations continue to play an important role in financing auto loan and lease originations across Europe. Germany and the U.K. are the largest and most well-established auto ABS markets (see chart 1).

Chart 1

Main market participants

The auto financing market is typically served by captive or non-captive entities (see table 1).

Table 1

In terms of market share, captive finance dominates public issuance in Europe.

• Volkswagen Group is the most prolific originator in Europe with a share of more than 16% of total originations over the past five years.
• The second biggest participant is on the other hand a non-captive entity, Santander Group, with approximately 13% of total originations over the past five years.
• The top 10 market participants comprise approximately 77% of originations, while the remaining share is subdivided among more than 25 captive and non-captive players (see chart 2).

Chart 2

Collateral types: Loan and lease receivables

The collateral pool in auto ABS transactions can include two products--loan or lease receivables--each with their own features (see tables 2 and 3).

Table 2

Table 3

Financial and operating leases

Table 4

The German auto ABS market has accounted for more than half of European auto lease ABS transactions over the past five years (see chart 3).

Chart 3

Typical Auto ABS Transaction Features

Auto ABS transactions usually have a shorter term than other asset classes (for example residential mortgage-backed securities) and are characterized by fast deleveraging.

Static and revolving transactions: Risks and mitigants

Transactions may start to amortize immediately after closing while some have a revolving phase that typically ranges from six months to two years. Revolving transactions' collateral can potentially deteriorate during the replenishment phase. Although we account for this potential deterioration risk in our credit and cash flow analyses, triggers are typically tight and mitigate this risk. If breached, the revolving phase will normally end early. Triggers include:

• Performance-related to ensure that delinquencies and defaults remain within certain thresholds;
• Concentration limits to ensure that the pools remain granular; and
• Asset-liability tests to ensure the outstanding liabilities do not exceed the performing collateral balance.

Sequential amortization and pro rata features: Risks and mitigants

When amortization starts, transactions may:

• Amortize sequentially until maturity;
• Amortize sequentially until a certain credit enhancement level is reached and then switch to pro rata; and
• Amortize pro rata.

Sequentially amortizing transactions feature an immediate build-up of credit enhancement for the senior notes that increases over time. On the other hand, pro rata transactions maintain a constant level of credit enhancement, accelerating amortization of the subordinated notes. Evidently, pro rata transactions lead to a certain degree of tail-end risk for the senior notes if defaults occur later in the transaction's life. For this reason, we normally test delayed recession or backloaded default curves in pro rata transactions.

The most typical mitigants are performance-related and normally, once breached, determine sequential amortization that cannot be reverted. Additional mitigants such as principal deficiency ledger triggers or clean-up call conditions may apply.

• Principal deficiency ledger: A mechanism by which losses (or defaults in jurisdictions where recovery timings are longer) are recorded on a ledger. Typically, when the losses or defaults recorded on the ledger exceed a certain threshold, excess spread in the transaction is trapped and used to cure losses, accelerating the repayment of the notes. We model this structural feature in our cash flow model.

• Clean-up call condition: Typically, it may be exercised when the collateral balance of the portfolio goes below 10% of the initial balance. If exercised, we believe this reduces tail-end risk.

Prime Collateral Underlies Robust Performance

Overall, the following factors collectively contribute to the strength of the European auto ABS market:

• Consistent and stable performance;
• A well-established and favorable legal framework;
• Accessibility as a reliable source of funding; and
• A practical and efficient risk transfer option.

Asset quality is typically prime in Europe, supported by historically low losses. Delinquencies and net losses usually remain negligible in mainland Europe. Also, in the U.K.--a market with some near-prime portfolios--net losses remain low. That said, on a relative basis, prime transactions still significantly outperform near-prime transactions (see charts 4 and 5).

Chart 4

Chart 5

Our rating transitions also reflect strong asset quality within portfolios in recent years, with upgrades significantly exceeding downgrades. No auto ABS tranches have defaulted to date (see chart 6).

Chart 6

New Trends

Auto ABS structures

Historically, auto ABS transactions have been structured with one to two classes of rated notes. The most senior liability would normally be 'AAA'-rated while the class B notes would typically be rated between 'AA' and 'A'. Nevertheless, over the past three to four years, transaction structures have been shifting toward so-called "full capital stack" structures for various reasons including:

• To address new funding needs stemming from the phase-out of the purchase programs led by central banks;
• To address recent higher demand from investors for higher yielding instruments;
• To account for capital relief considerations for originators; and
• To achieve significant risk transfer.

Also, recent monetary policy revisions adopted by the European Central Bank (ECB) and the Bank of England have once again changed issuance dynamics. While during and immediately after the COVID-19 pandemic, retained transactions were more popular, investor-placed issuance volumes have returned to pre-pandemic levels (see chart 7).

Chart 7

Transition to used vehicles

Used vehicle auto securitizations have become more common. This was initially partly due to higher margins, which can generally be charged on used auto loans. However, this trend became even more pronounced following COVID-19 related new vehicle shortages, which also caused used car prices to soar (see chart 8). Despite most shortages being resolved, used car prices remain high. Consequently, portfolios comprising used vehicles as collateral--especially in non-captive portfolios--continue to rise. While lower new vehicle registrations may temper issuance, we believe this may be counterbalanced by a higher issuance of portfolios backed by mainly used vehicles.

Chart 8

Transition to electric vehicles

As part of their commitment to the net-zero green transition, original equipment manufacturers (OEMs) are shifting their production and sale models toward electric vehicles. Certain countries are adopting electric vehicles faster than others, such as Germany and the U.K., given broad and country-specific subsidies and tax discounts, and the infrastructure available (see chart 9).

Chart 9

Captive portfolios contain a greater proportion of electric vehicle assets. The share of electric vehicle assets in German auto ABS pools normally varies between 10% and 30%, but some exceptions apply.

Chart 10

Interestingly, the volume of vehicles entering the secondhand car market has been low. We believe the following factors have contributed to this trend:

• OEMs prioritize their electric vehicle lease contract products so they can have more control of the vehicle's residual value. Additionally, the industry is moving toward an extension of the typical three- to four-year lease term to up to nine years. This will extend the time it takes for electric vehicles to reach the secondary market.
• Available subsidies and allowances mainly apply to new electric vehicles.

The fact that those vehicles do not hit the used car market reduces the availability of adequate data on residual values for electric vehicles. Also, currently data show that electric vehicles' residual values are lower than combustion engines. For those reasons, our analytical approach may apply greater residual value and recovery stresses for transactions containing a high proportion of electric vehicle assets.

Shift toward lease products and subscription models

Historically, loans have been the most common form of vehicle financing in Europe. However, leasing has become increasingly popular as a more flexible finance product for customers. This, in turn, has increased auto lease assets within securitized portfolios (see chart 11).

Chart 11

The subscription model is also becoming more popular, with several OEMs offering a broad range of options. For instance, customers can now subscribe to some infotainment software of their leased vehicles, but also have the option to subscribe to usage of the vehicles (see chart 12).

Chart 12

Quantitative tightening and negative excess spread

Average interest rates charged to customers have been gradually falling since 2009 and have only recently started to increase. On the other hand, the ECB's main refinancing operations rate has rapidly increased from 0% in July 2022 to 4.5% in September 2023. Similarly, also in the U.K. the policy rates have materially increased across the same time span. Consequently, the cost of swaps and liabilities in ABS transactions has significantly and quickly increased. That said, over the same period, the average interest rate charged on auto portfolios rose by a much smaller extent.

Chart 13

Although interest rates are now rising, it will take some time before the underlying collateral of auto ABS transactions can fully offset these higher rates. Therefore, originators and arrangers have created various features to help mitigate lower excess spread in their transactions.

• Fee reserves: These reserves lower the transaction maintenance cost for the special-purpose entity (SPE) as the originators fund a reserve that covers the stressed servicing fee throughout the transaction's life. We normally apply a stressed servicing fee because if the servicer becomes insolvent, the SPE will need to offer fees that are at or above market standard to attract a replacement servicer. These reserves may be funded at closing or upon a rating trigger being breached.
• Higher discount rates: Excess spread is artificially created by increasing the discount at which the portfolio is sold to the SPE.
• Swap paid upfront: The originator may pay the swap counterparties at closing, outside of the payment waterfall. This reduces the issuer's overall cost.
• Cash support: Originators commit to compensate the negative difference between the transaction's cost and the portfolio's yield through a cash transfer mechanism.

Loans And Leases: Specific Features, Main Risks, And Our Considerations

Table 5

Table 6

The growth of the auto lease industry and associated lease-linked services has introduced an additional set of risks for transactions backed by such assets (see table 8).

Table 7

Other risks stemming from the servicer's bankruptcy and typical mitigants

Commingling risk.  The risk that if a bankrupt servicer is subject to liquidation, funds belonging to the SPE may be commingled with the servicer's estate. The typical mitigants we observe in European auto ABS transactions are commingling reserves and declaration of trusts over servicer bank accounts.

Setoff risk.  This risk arises when the obligors have certain counterclaims against the seller that can be exercised against the assets which form the issuer's property. In this event the collateral balance could be reduced, and the issuer would suffer a loss. Several types of setoff risk apply, such as deposit, employee, and insurance. Reserves can mitigate this risk, as well as eligibility criteria and portfolio limits.

Appendix

Related Research

• European Auto ABS Index Report Q3 2023, Nov. 9, 2023
• Economic Outlook Eurozone Q4 2023: Slower Growth, Faster Tightening, Sept. 25, 2023

Editor: Claire Ellis.