Rarely is ABS challenged in court, but when it is, it can set precedent for years to come. As of its bankruptcy filing, Hertz had $10.2 billion in ABS notes outstanding, including $7.7 billion in Class A (formerly AAA-rated) senior tranche. As expected, the Chapter 11 event triggered a rapid amortization of its master trust. Then, on June 11th, Hertz lawyers filed a motion to reject the leases on over 144,000 vehicles pledged therein (about 30% of their total fleet) and requested that each be treated instead as an individual obligation. The trust indenture language states, however, that Hertz may only accept or reject the master lease in its entirety. Nevertheless, Hertz management wishes to keep a portion of the trust’s vehicles in service. This can be potentially detrimental to ABS bondholders since the vehicles earmarked for liquidation may cease cashflows to certain tranches during the sale process. Thus, the prospect of bondholders not being made whole is very real under the modified trust proposal.
This type of legal maneuver is concerning. Investors, rating agencies, and Wall Street research departments have (rightfully) assumed to date that the master trust holds an ironclad blanket lease encompassing all pledged vehicles. Hertz, a single-B unsecured entity prior to bankruptcy, has clearly benefited from favorable financing costs associated with the issuance of investment-grade rated ABS. Furthermore, since Hertz filed the court challenge, Moody’s has not only downgraded Hertz’s securitizations but also those of AVIS (AESOP shelf). So, the legal ramifications of this case have already had wide-ranging implications for the sector.
The court has assigned Judge Mary Walrath to the case – an experienced judge who presided over the ANC rental car bankruptcy in 2001, among others. Back then, ABS bondholders were made whole based on the sanctity of the bankruptcy remote indenture language. Other past challenges to the securitization concept include LTV steel’s bankruptcy (trade receivables securitization) and Enron’s liquidation — including its myriad of off-balance sheet structures which ultimately precipitated an overhaul to securitization accounting rules. In the years to follow, ABS investors would joke that “securitization is bankruptcy remote – perhaps even in the event of a bankruptcy.”
Hertz ABS investors aren’t laughing now. Lawyers for the Structured Finance Association have struck a tentative compromise with those at Hertz to continue fixed payments to the master trust. These monthly payments will be approximately 2/3rds of that prior to bankruptcy and will last six months. In the meantime, Hertz will liquidate a percentage (40% or more) of their overall fleet in an orderly fashion – passing proceeds from vehicles pledged to the trust onto ABS bondholders. The good news is that the used car market is strong this summer. Cox Industries’ Manheim Index hit record highs in July, and Hertz car sales have historically tracked the Manheim closely (see HertzCarSales.com). It’s also worth noting that Hertz’s plan to reduce their fleet by 144,000+ vehicles would only be a relatively small fraction of the 40+ million annual domestic used car market. In fact, Hertz was able to liquidate almost 40,000 cars in May alone.
Since February, over $2bn in HERTZ ABS paper has exchanged hands. Last week, the seniors were quoted with a $99-16 / $100-00 market in block size, while the B/C/D’s were trading at or above the mid-$80’s. This is a tremendous improvement from May. The most recent remittance report supports this. It showed Hertz seniors still having credit enhancement of about 30%, only a slight decline from the 32+% prior to March. The trust does have a LOC (Line Of Credit) in place to insure timely principal and interest to cover short-term cash shortfalls.
At IR+M, we’ve steered clear of rental car ABS (pun intended), but we believe this case is worth watching closely. We are intrigued by the senior tranches – 30% is a tremendous amount of enhancement even under these circumstances. But with a yield in the 2.5% range, the compensation for this risk isn’t enough right now. The risk/return of the subordinate tranches are a completely different story. The enhancement is significantly less and the tranche slices are much thinner (i.e. the amount of the collateral value assigned to that subodinate tranche). So, the pandemic induced collapse in rental car demand followed by a parent bankruptcy and subsequent court challenge to the master trust is rightfully stoking fear of principal loss in the Hertz subordinate ABS market. While this chain of events is not common, it does demonstrate how fragile subordinate tranche principal can be. In the fall of 2019, we published a mailer addressing this topic in more detail:
Hertz ABS investors may eventually be made whole if the used car market and the economy continue to improve. But studying this nuanced situation can be invaluable over the long run. The downside scenario in May was ugly — some Hertz ABS subordinates traded below $70 while suffering severe downgrades and facing the specter of 100% principal loss. That’s tremendous risk for a marginally higher coupon of 50-250bps in 2019. Hindsight is 20/20, and many ABS subordinates never walk this dark path, but, as the saying goes, “those that do not learn history are doomed to…”
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