Asset-Backed Securities Can Withstand Higher Unemployment

Securities backed by credit card and automobile loans could withstand significant increases in unemployment from current levels before ‘BBB’ or ‘AAA’ bonds default, but downgrade risk persists, Fitch Ratings says.

Fitch’s study, which focused primarily on the level of unemployment that would cause first dollar defaults in auto loan and credit card ABS transactions, determined that typical ‘AAA’ rated transactions could withstand an increase in the unemployment rate of up to 20%, all other factors being equal. In addition Fitch determined that typical ‘BBB’ rated transactions could withstand an increase in the unemployment rate of up to 10%, again with all other factors being equal.

According to Fitch:

• Prime credit card chargeoffs are expected to increase on a 1:1 basis. Accordingly, a 100% increase in the base unemployment rate, from 5% to 10%, would lead to a 100% increase in the prime credit card chargeoff index, from 6.18% (April 2008) to 12.36% over the next 12 months.
• Subprime credit card chargeoffs and prime and subprime auto loan net losses are expected to increase at a rate closer to 1.2−1.3:1, meaning a 100% increase in unemployment could lead up to a 130% increase in losses.

Most credit card and auto ABS bonds can withstand a major unemployment shock before a loss occurs, but it does not mean they are immune to downgrade. - Kevin Duignan, Managing Director and head of Fitch’s U.S. ABS group.

Fitch’s study also focused on how quickly unemployment rate shocks translate to ABS losses and the differences between auto loan & credit card transaction performance during the unemployment shocks. The effect of rising unemployment on auto & credit card performance tends to lag the actual rise in unemployment by three-to-six months.

Additionally, consumers are more likely to default on credit cards before auto loans following a shock to unemployment. Given the recent jump in unemployment, Fitch expects credit card and auto loss indices to continue climbing in the third and fourth quarter of this year.

The special report, Will Consumer ABS Crack Under Unemployment Pressure? is available for purchase.