Positioned squarely at the intersection of the used vehicle market, auto ABS and the effects of the coronavirus crisis on American's mobility is the Hertz bankruptcy filing. Similar to the large bankruptcies, marking the 2008 financial crisis, such as Lehman Brothers and WAMU, which shaped the financial sector's recovery, the outcome of the Hertz bankruptcy is likely to impact the direction of auto ABS and the underlying auto market in the years ahead.
Hertz Debt Problems
As air travel has been grounded, rental car usage has gone off the proverbial cliff. By itself, COVID-19 would be enough to take the industry down, and Hertz is not the only rental agency to file bankruptcy. But Hertz rolled into the coronavirus crisis worse off than other rental car players. It was loaded up with massive debt through direct borrowing and ABS bonds backed by its fleet of used vehicles. As reported in the Wall Street Journal, Hertz increased its ABS-related borrowing by 40% over the past two years, topping out at $14.4 billion.
In normal times, Hertz's business model relies on a stream of rental car payments to fuel repayment of that debt.
That Sinking Feeling
With a large payment owed to ABS bondholders and only a fraction of Hertz's fleet being utilized, vehicle sales might seem like a good alternative source of cash. But given the current economic uncertainty and stay-at-home orders, supply is outstripping demand. According to Manheim, wholesale used vehicle prices fell 11.4% from March to April.
Although there are some signs that the used vehicle wholesale market, which froze during the height of the crisis, is starting to move again, a mass unloading of Hertz cars to pare down to the current operating level - reported to be around 15% of fleet utilization - would put even more pressure on prices and for a potentially extended period of time. It would not take months but years for Hertz to liquidate its fleet of 500,000 vehicles, even if Hertz is able to return some vehicles to the manufacturers through their guaranteed depreciation programs. That's a large and lengthy supply of used vehicles entering the void of a stalled market.
The prospect of accelerated depreciation on used vehicles creates challenges for Hertz under its ABS-related transactions.
According to Hertz's bankruptcy filing, Hertz's debt structure includes a series of transactions with affiliated entities, some of which are not currently in bankruptcy, which issue notes to fund vehicle purchases and to make vehicle purchases. Hertz leases the vehicles from the non-debtor affiliate owner and the notes, which are backed by the vehicles, are paid through the lease payments.
As a protection for bondholders, the structure includes a mark-to-market feature to test vehicle value and monthly vehicle depreciation. Hertz must pay when the vehicles backing the bonds depreciate faster than planned, based on a pricing guide. In the past, rating agencies were satisfied that investors were adequately protected against depreciation of the vehicle collateral. Depreciation was on the rise but not considered a significant risk.
Now, given the market dynamics, Hertz's "true up" obligation related to depreciation may raise issues similar to those we observed with respect to enforcement of repurchase agreements under warehouse lines of credit for subprime residential mortgages during the last financial crisis and, more recently, regarding repurchase agreements related to commercial mortgage-backed securities. Under the terms of those agreements, borrowers have challenged margin calls and foreclosures related to declines in collateral value on the basis of unreasonable valuations during a time of severe market disruption. Inherent in valuation disputes is often a tension between a lender's desire to liquidate collateral as soon as possible given the potential for further declines and a judicial determination as to a reasonable disposition process.
Whether and when Hertz's used vehicles adds to the sea of vehicles already on the market - and we mean, "sea" literally, as boatloads of new vehicles wait offshore for space to be made on dealer lots - will depend on how Hertz's bankruptcy case proceeds. A depressive effect on prices due to oversupply is bound to have an impact on auto ABS performance - greater depreciation creates greater negative equity, which, in turn, negatively impacts consumers' willingness to continue making finance payments, leading to risks for both used and new vehicle ABS deals.
Despite all of the foreseeable negative effects of Hertz's troubles, the uncertainty of the times actually creates the potential for a positive outcome for the rental car industry. Until there is a vaccine, the prospect of returning to cramped public transportation is a serious consideration for many. Cheaper gas prices, combined with the benefit of a controlled and isolated environment of a vehicle, may be appealing to many in the immediate future. Car-driven domestic travel might take preeminence over longer distance journeys. There is a possibility that rental cars bounce back as long as companies can give some assurance they're delivered clean.
For those rental car companies who can weather the storm, there could be brighter days ahead.
But, for now, greater than expected depreciation could cause auto ABS to lose some shine.
Massimo Giugliano, Nicolas Diefenbacher and Nicole Serratore, members of the Insolvency, Creditors' Rights & Financial Products Practice Group of Davis & Gilbert, contributed to this post.
Originally published June 01, 2020.
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