Scope Ratings has assigned ratings to four credit-linked notes issued by Banco Santander SA (Santander) which reference the credit performance of a US auto loan portfolio originated and serviced by Santander Consumer USA Inc.

The assigned ratings are as follows:

Class C: USD 96.7m (7.00%): assigned new (P)A_SF

Class D: USD 60.8m (4.40%): assigned new (P)BBB-_SF

Class E: USD 34.5m (2.50%): assigned new (P)BB_SF

Class F: USD 23.5m (1.70%): assigned new (P)BB-_SF

The ratings assigned by Scope reflect the risk for the credit linked note (CLN) investor to cover a loss stemming from credit events in the reference portfolio under the CLNs’ terms. The ratings do not address potential losses resulting from an early notes redemption, nor any market risk associated with the notes. Scope did not assign a rating to the credit linked notes of Class A, Class B, Class G and Class H. The notes’ maturity is [?].

Coupons have not been considered as they were not known yet. The asset analysis considered the reference portfolio as of 28 February 2019.

The credit linked notes constitute direct obligations of Banco Santander and reference the credit performance of a static USD 1,381.5m portfolio of high-quality-obligors’ auto loans in the United States (US). The reference portfolio comprises 62,977 loans for new and used vehicle acquisition and shows no significant concentration, Top20 exposures only account for 0.12% of the portfolio balance. The CLN investors fund the collateral account held at Santander, up to the amount they have committed to under the notes. This collateral is available to cover credit losses from the reference portfolio. The CLN investors split into eight different classes, where each class presents a certain claim in the repayment of collateral, following portfolio amortisation or the realisation of recovery proceeds, but also an obligation to cover for portfolio credit losses, in reverse order of seniority. The repayment of the Classes A to G follows a pro-rata amortisation schedule, subject to a 2.7% cumulative loss trigger that changes the schedule to sequential amortisation. The Classes A to F also benefit from an exclusion of the Class G from amortisation until the note represents 7.5% of the combined outstanding notes’ balances. The repayment of Class H will always remain subordinated. The initial credit enhancement levels from subordination for the respective class of CLNs are: 24.50% for Class A, 23.50% for Class B, 16.50% for Class C, 12.10% for Class D, 9.60% for Class E, 7.90% for Class F and 3.20% for Class G. Class H has no credit enhancement.

Under the credit linked notes, Santander would receive from the paid-in collateral cash payments equal to the loss that the bank determines on defaulted reference asset, in line with its internal loss calculation under IFRS9. The amount is then adjusted for the actual loss during a maximum work-out period of 12 months. Losses are allocated to the respective tranches in reverse order of seniority, i.e. from Class H to A.

The CLN terms and conditions define loan default as i) a failure to pay with respect to the reference obligation; ii) a bankruptcy of the obligor; or iii) a loss from the restructuring of a reference obligation. The credit protection agreements grant significant supervisory rights to the external verification agent, a reputable global accounting firm. This agent ensures that all loss claims are valid, and the determination of the expected loss and final loss comply with Santander’s internal policies. Santander also must demonstrate to the verification agent that its servicing and work-out processes accord with the bank’s internal business principles and policies. The verification is however limited to a certain number of defaulted cases, reflecting the high granularity of the portfolio.

Rating rationale

The ratings reflect the legal and financial structure of the CLN issuance as defined under the terms and conditions of the notes; the credit quality of the underlying portfolio in the context of macroeconomic conditions in the US; the incentives and credit quality of Santander as protection buyer and account bank; the abilities of SCUSA, the servicer of the reference loans; and the supervision from the verification agent, a reputable global accounting firm.

The ratings account for the respective credit enhancement of the classes of notes and the pro-rata release of risk coverage reflecting reference portfolio amortisation, which is subject to a performance trigger. The ratings also capture the credit risk of the highly granular reference portfolio, which is composed of well-seasoned amortising auto loans with high loan-to-value (LTV) ratios extended to good-quality obligors in the US.

The ratings reflect the sensitivity of the instruments to changes in analytical assumptions as well as the timing of defaults, driven by the evolution of absolute credit enhancement available under the pro-rata amortisation mechanisms.

The ratings incorporate our view on a potential US economic slowdown, in the context of the portfolio’s relatively limited 4.5-year risk horizon. The currently low level of unemployment and the generally good credit quality of the obligors, based on FICO scores, also limit the impact of economic stress on the portfolio.

The ratings also reflect the counterparty risk exposure of the credit-linked notes to Banco Santander SA (AA-/Stable/S-1+) as payer of the coupon and holder of the collateral account. The bank’s credit quality limits the CLN ratings, as the collateral account holds the funds available for loss coverage and note repayment.

Key rating drivers

Positive asset selection (positive). The portfolio is positively selected with respect to the FICO scores of the obligors and the financing of new and used vehicles, compared to the net loss performance data presented by SCUSA.
The portfolio is also well seasoned, which reflects positively on expected portfolio defaults.

Limited macroeconomic exposure (positive). The pro-rata amortisation of the notes and the relatively short remaining term of the underlying loans limit the exposure of the non-senior tranches to the envisaged economic slowdown in the US. The impact is also mitigated by the high quality of borrowers.

Experienced staff, limited track record (positive). Industry experience of staff members ranges from 10 years to more than 30 years. SCUSA’s origins in sub-prime auto lending complement the company’s push into the prime segment.

Efficient synthetic structure (positive). The transaction works with an immediate loss-determination mechanism reflecting Santander’s IFRS 9 provisions. This mechanism is in line with the quick realisation of recovery proceeds due to SCUSA’s repossession and sales processes in addition to limiting the counterparty exposure to Santander.

Pro-rata amortization (negative). The amortisation mechanisms erode absolute credit enhancement for the highest tranches. This is partially mitigated by a pro-rata stop trigger set at 2.7% cumulative losses and class G’s exclusion during early pro-rata periods.

High LTV, low default risk (negative). Portfolio loans have high loan-to-value ratios, at more than 96% on average, which reflects negatively on recovery proceeds. This is mitigated by the high obligor quality (average FICO score at 753) as well as moderate levels on average for the payment-to-income ratio (8%) and debt payment-to-income ratio (30%), which reduce the likelihood of a foreclosure.

Default reclassification (negative). Santander can reclassify bankruptcy and failure-to-pay cases as restructuring, which leaves restructured loans in the reference portfolio and could have an adverse impact on transaction performance. Our calibration of portfolio loss parameters based on net losses and the relatively high volatility mitigates this. Moreover, Santander has to adhere to its internal servicing practices and standards.

Counterparty risk (negative). All funds available for note repayment are exposed to the credit quality of Santander (AA-/Stable/S-1+), the holder of the collateral account. A replacement of the bank as account holder upon loss of BBB- partially mitigates the risk.

Key rating-change drivers

Positive. Faster-than-expected amortisation following the early activation of the cumulative loss trigger may reflect positively on the rated instruments

Negative. Significantly higher unemployment may increase defaults in the reference portfolio.

Negative. Head-line risk related to Fiat Chrysler, given the portfolio’s high share of vehicles from this company, may reduce recovery rates.

Asset analysis

The reference loan portfolio is static and comprises 62,977 auto loans mainly granted to US private individuals. The borrowers under these loans predominantly qualify as prime borrowers, with an average FICO score of 753 and a range from 630 to 900. The loans financed the acquisition of new and used vehicle mainly from Fiat Chrysler Automobiles (96.9% of current loan balance), together with attached insurances, service charges and taxes. The obligors show moderate levels of payment-to-income of 8% on average and debt payment-to-income of 30.4% on average, which offsets partially the rather high average loan-to-value of 96.4%.

The amortising loans in the reference portfolio are comparably old, reflected in 1.4 years average seasoning and 4.5 years average remaining term. The short life limits the exposure of the notes to the slowing macroeconomic conditions in the US. Intensifying pressure from the trade conflicts with China and other trade partners may result in increases of unemployment levels, up from the currently 3.6%, which may result in increasing default rates in the underlying reference portfolio.

The portfolio is well distributed across the US, with a highest regional concentration in Texas, 13.4% of the portfolio balance, reflecting the business focus of Santander Consumer USA (SCUSA).

The relatively high LTV results in relatively limited recovery proceeds. SCUSA has shown a relatively stable track record on recoveries of approx. 50%, mainly resulting from selling repossessed vehicles in auctions.

Quantitative assumptions

Scope performed a projection of losses on the different tranches, incorporating the collateral release and loss-allocation mechanisms as well as the credit enhancement of the respective CLN, outlined in the CLNs’ terms and conditions.

The analysis used a large homogenous portfolio approximation approach to analyse the highly granular collateral pool. Scope assumed that portfolio defaults followed an inverse Gaussian distribution to calculate the expected loss of the rated notes. The analysis also provided the expected weighted average life of each class of notes. Scope’s analysis considered the combined portfolio.

Scope derived a portfolio ’90-days-past-due mean default rate of 6.1% over a portfolio weighted average life of 3.1 years and a coefficient of variation of 50% for the portfolio from net loss vintage data and previous transactions’ recovery data. Scope considered a base case recovery rate of 50%. The rating conditional recovery rates are therefore: 50% for B, 45% for BB, 40% for BBB, 35% for A, 30% for AA and 25% for AAA.

Net loss vintage data provided by SCUSA referenced a 120-days-past-due default definition and covered a period from 2013 to 2019, a period of average stress in the US auto loan market. The bank did not provide role-rate information for the period between 90 and 120 days-past-due.

Scope analysed the transaction under a high (20%) and low (0%) prepayment assumption.

Stress testing
Stress testing was performed by applying rating-adjusted recovery rate and assumptions

Cash flow analysis
This is a synthetic transaction; thus, Scope did not do a cash-flow analysis. The equivalent is the loss-allocation and risk cover release analysis, which considered the amortisation vectors from the assets and took into account the transaction’s main structural features, such as the notes’ priorities of payments, note size and the coupon on the notes. This analysis produces an expected loss and expected weighted average life for the notes.
Scope performed this analysis with the use of Scope Cash Flow SF Model Version 1.0.0.

Rating sensitivity
The stability of the ratings is supported by: i) strong protective mechanisms in the structure; and ii) Scope’s use of both rating-conditional recovery rate assumptions and a long-term performance reference for the assets.
Scope tested the sensitivity of the analysis to deviations from the main input assumptions: i) the mean default rate; ii) recovery rates; and iii) the mean default coefficient of variation.

• Class C: sensitivity to mean default rate + 50%, three notches; sensitivity to recovery rates – 50%, two notches; sensitivity to coefficient of variation + 50%, two notches
• Class D: sensitivity to mean default rate + 50%, one notch; sensitivity to recovery rates – 50%, one notch; sensitivity to coefficient of variation + 50%, one notch;
• Class E: sensitivity to mean default rate + 50%, two notches; sensitivity to recovery rates – 50%, one notch; sensitivity to coefficient of variation + 50%, zero notches;
• Class F: sensitivity to mean default rate + 50%, one notch; sensitivity to recovery rates – 50%, one notch; sensitivity to coefficient of variation + 50%, one notch.

Methodology
The methodologies applied for this rating is the Consumer and Auto ABS Rating Methodology. Scope also applied the principles contained in the Methodology for Counterparty Risk in Structured Finance. All documents are available on www.scoperatings.com.
Scope analysts are available to discuss all the details of the rating analysis and the risks to which the credit linked notes are exposed.

Solicitation, key sources and quality of information
The rated entity and/or its agents participated in the rating process.
The following substantially material sources of information were used to prepare the credit rating: public domain, the rated entity, the rated entities’ agents, third parties and Scope internal sources.
Scope considers the quality of information available to Scope on the rated entity or instrument to be satisfactory. The information and data supporting Scope’s ratings originate from sources Scope considers to be reliable and accurate. Scope does not, however, independently verify the reliability and accuracy of the information and data.
Scope Ratings GmbH has not received a third-party asset due diligence assessment/asset audit. Scope has performed its own analysis of the data quality, based on information received from the rated entity or related third parties, which is not and should be not deemed equivalent to the performance of due diligence or an audit. We also relied on the fact that assets have to comply with eligibility criteria, otherwise loss claims would be void. The internal analysis was considered when preparing the rating and it has no impact on the credit rating.
Prior to the issuance of the rating or outlook action, the rated entity was given the opportunity to review the rating and the principal grounds on which the credit rating is based. Following that review, the rating was not amended before being issued.

Regulatory disclosures
This credit rating and/or rating outlook is issued by Scope Ratings GmbH.
Lead analyst Sebastian Dietzsch, Director
Person responsible for approval of the rating: Karlo Stefan Fuchs, Managing Director
The ratings were first released by Scope on 19.06.2019.
The ratings concern a financial instrument, which has been rated by Scope for the first time.

Potential conflicts
Please see www.scoperatings.com for a list of potential conflicts of interest related to the issuance of credit ratings.

Conditions of use / exclusion of liability
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