Fitch Takes Rating Actions on Two Pepper SPARKZ Transactions amid Coronavirus Review

(The following statement was released by the rating agency) Fitch Ratings-Sydney-06 July 2020: Fitch Ratings has taken rating actions on two Pepper SPARKZ Trusts, which consist of notes backed by pools of first-ranking Australian automotive and equipment loan and lease receivables originated by Pepper Asset Finance Pty Limited, a subsidiary of Pepper Group Pty Limited (Pepper). The notes were issued by BNY Trust Company of Australia Limited as trustee. Fitch has upgraded the class B notes and affirmed the remaining five tranches from Pepper SPARKZ Trust No. 1 (SPARKZ 1) to reflect credit enhancement build-up. Fitch has concurrently downgraded the class F notes and affirmed the remaining six tranches from Pepper SPARKZ Trust No.2 (SPARKZ 2). The class F notes were downgraded due to the notes' sensitivity to the potential increase in defaults and decrease in recoveries as a result of the coronavirus pandemic. For SPARKZ 1, the social and market disruptions caused by the coronavirus and related containment measures did not negatively affect the ratings because there is sufficient credit enhancement to cover expected higher defaults and reduced recoveries, and because Fitch views liquidity protection as sufficient to support the current and upgraded ratings. The sensitivity of the ratings to scenarios more severe than currently expected is provided in the Rating Sensitivities section. The Stable Outlook on all of the notes from SPARKZ 1 and the senior notes (classes A1-a, A1-x, B and C) from SPARKZ 2 reflect the liquidity support and the notes' ability to withstand the sensitivity to higher defaults and lower recoveries stemming from the pandemic. For SPARKZ 2, the Outlook on the class D and E notes have been revised to Negative from Stable, while the Outlook on the class F notes, which have been downgraded, is also Negative. This is because the notes have not yet built up sufficient credit enhancement to cover the potential increase in defaults and decrease in recoveries as a result of the pandemic. The potential rise in defaults and fall in recoveries do not have any rating impact on classes A1-a, A1-x, B and C, which is in line with Fitch's through-the-cycle approach. Under this approach, lower rating levels tend to be more vulnerable to deterioration in macroeconomic conditions. Pepper SPARKZ Trust No. 1 ----A1-a AU3FN0048633; Long Term Rating; Affirmed; AAAsf; RO:Sta ----B AU3FN0048658; Long Term Rating; Upgrade; AA+sf; RO:Sta ----C AU3FN0048666; Long Term Rating; Affirmed; Asf; RO:Sta ----D AU3FN0048674; Long Term Rating; Affirmed; BBBsf; RO:Sta ----E AU3FN0048682; Long Term Rating; Affirmed; BBsf; RO:Sta ----F AU3FN0048690; Long Term Rating; Affirmed; Bsf; RO:Sta Pepper SPARKZ Trust No.2 ----A1-a AU3FN0052338; Long Term Rating; Affirmed; AAAsf; RO:Sta ----A1-x AU3FN0052346; Long Term Rating; Affirmed; AAAsf; RO:Sta ----B AU3FN0052353; Long Term Rating; Affirmed; AA+sf; RO:Sta ----C AU3FN0052361; Long Term Rating; Affirmed; A+sf; RO:Sta ----D AU3FN0052379; Long Term Rating; Affirmed; BBB+sf; RO:Neg ----E AU3FN0052387; Long Term Rating; Affirmed; BB+sf; RO:Neg ----F AU3FN0052395; Long Term Rating; Downgrade; B+sf; RO:Neg KEY RATING DRIVERS Coronavirus-Related Economic Shock: Fitch has made assumptions about the spread of the coronavirus and the economic impact of the related containment measures. As a base-case (most likely) scenario, Fitch assumes a global recession in 1H20 driven by sharp economic contractions in major economies with a rapid spike in unemployment, followed by a recovery that begins in 3Q20 as the health crisis subsides. Fitch's downside (sensitivity) scenario in the Rating Sensitivities section below takes into consideration a more severe and prolonged period of stress, with recovery to pre-crisis GDP levels delayed until around the middle of the decade. Coronavirus-Related Impact: The measures put in place to limit the virus spread are affecting Australia's economy, with many businesses continuing to experience a decline in income. We expect these measures to affect loan performance and this has been factored into our revised base-case assumptions. Liquidity Risk from Payment Holidays: We have reviewed the ability of the transactions to survive a significant proportion of borrowers being offered and taking up a payment holiday. The transactions benefit from liquidity facilities sized at 1.25% of the outstanding A1-a, A1-x, B and C notes balance. The transactions can withstand over 85% of the portfolio being granted a payment holiday for six months, which is well above the 7.7% of receivables under payment holiday arrangements as of end-May, before needing to draw on the facilities. Obligor Default Risk: Obligor default and recovery rates are key assumptions in Fitch's quantitative analysis. Fitch took into consideration the historical performance of Pepper's portfolio in reviewing the base case assumptions, as well as the performance of US auto loan receivables during the global financial crisis. The base case default rates were increased by 1.5x and recovery rates were reduced by 0.9x as a result. Fitch also adjusted its rating stress multiples and haircuts to reflect Fitch's through-the-cycle approach and to account for the fact that its base cases incorporate an additional element of economic stress. The revised assumptions are shown below and were applied in this analysis. Base-case default expectations (and 'AAAsf' default multiples) are as follows: Tier A: 4.7% (4.2x) Tier B: 9.3% (4.0x) Tier C: 16.5% (3.2x) The recovery base case applied was 17.2% for all risk grades with a 55.8% 'AAAsf' recovery haircut. As of the June payment date, 30+ day arrears were 1.9% for SPARKZ 1 and 1.3% for SPARKZ 2, compared with the 1Q20 Dinkum ABS Index 30+ day arrears of 2.29%. All losses (0.6% for SPARKZ 1; 0.1% for SPARKZ 2) have been covered by excess spread. Fitch expects loan performance to deteriorate in the near term, but to continue to support the Stable Outlooks for most of the notes. Fitch forecasts Australia's GDP to contract by 2.7% in 2020, with an unemployment rate of 7.1% by end-2020. This is to be partially offset by a low cash rate of 0.25% and the application of both central bank and government stimulus measures. Fitch expects GDP growth to bounce back to 3.1% in 2021 and for the unemployment rate to fall to 6.7% in the medium term. Cash Flow Dynamics: Cash flow analysis was performed for SPARKZ 1 and the class A1-a, C, D, E and F notes can withstand all Fitch stresses at their current rating levels. The class B notes have been upgraded one notch to 'AA+sf' from 'AAsf', reflecting the increase in credit enhancement supporting the notes. Cash flow analysis was also performed for SPARKZ 2 and the class A1-a, A1-x, B and C notes can withstand all Fitch stresses, at their current rating levels. The Outlooks on the class D and E notes have been revised to Negative and the Outlooks on the class F notes, which have been downgraded by one notch, is also Negative, reflecting their ratings' vulnerability to downgrade due to the potential increase in defaults and decrease in recoveries as a result of the pandemic. Structural Risk: Structural risk was evaluated in the initial transaction analysis through the review of transaction documentation, legal opinions and structural features. There have been no material changes to any transaction since closing. Counterparty Risk: Counterparty risk was evaluated in the initial transaction analysis through the review of transaction documentation, legal opinions and structural features. There have been no material changes to any transaction counterparties since closing. Servicer, Operational Risk: All receivables were originated by Pepper Asset Finance, which demonstrated an adequate capability as originator, underwriter and servicer. Fitch undertook an onsite operational review and found that the operations of the servicer were consistent with the market standards for auto and equipment lenders. Collection and servicing activities have not been disrupted by the pandemic, as staff members are able to work remotely and have access to the office, if needed. Residual Value Risk: There is no residual value exposure in this transaction. However, there is a small exposure to balloon loans. RATING SENSITIVITIES This section provides insight into the model-implied sensitivities the transactions face when one assumption − defaults and/or recoveries − is stressed, while holding others equal. The modelling process uses the estimation and stress of default and recovery assumptions to reflect asset performance in a stressed environment. The results below should only be considered as one potential outcome, as the transactions are exposed to multiple dynamic risk factors. Factors that could, individually or collectively, lead to positive rating action/upgrade: Macroeconomic conditions, loan performance and credit losses that are better than Fitch's baseline scenario or sufficient build-up of credit enhancement that would fully compensate for the credit losses and cash flow stresses commensurate with higher rating scenarios, all else being equal. SPARKZ 1 The class A1-a notes are rated at 'AAAsf', which is the highest level on Fitch's scale. The ratings cannot be upgraded. Upgrade Sensitivity: Impact on note ratings of multiple factors Class B / C / D / E / F Current rating: AA+sf / Asf / BBBsf / BBsf / Bsf Decrease defaults by 10%; increase recoveries by 10%: AAAsf / AAsf / A-sf / BBB-sf / B+sf SPARKZ 2 The class A1-a and A1-x notes are rated at 'AAAsf', which is the highest level on Fitch's scale. The ratings cannot be upgraded. Upgrade Sensitivity: Class B / C / D / E / F Impact on note ratings of multiple factors Current rating: AA+sf / A+sf / BBB+sf / BB+sf / B+sf Decrease defaults by 10%; increase recoveries by 10%: AAAsf / AA-sf / A-sf / BB+sf / B+sf Factors that could, individually or collectively, lead to negative rating action/downgrade: A longer pandemic than Fitch expects that leads to deterioration in macroeconomic fundamentals and consumers' financial position in Australia beyond Fitch's baseline scenario. Available credit enhancement cannot compensate for higher credit losses and cash flow stresses, all else being equal. Fitch conducted sensitivity analysis by increasing gross default levels and decreasing recovery rates over the life of the transaction. SPARKZ 1 Downgrade Sensitivity: Impact on note ratings of increased defaults: Class A1-a / B / C / D / E / F Current rating: AAAsf / AA+sf / Asf / BBBsf / BBsf / Bsf Increase defaults by 10%: AAAsf / AA+sf / Asf / BBBsf / BBsf / below Bsf Increase defaults by 25%: AAAsf / AAsf / A-sf / BBB-sf / B+sf / below Bsf Increase defaults by 50%: AA+sf / A+sf / BBBsf / BBsf / below Bsf / below Bsf Impact on note ratings of decreased recoveries: Current rating: AAAsf / AA+sf / Asf / BBBsf / BBsf / Bsf Reduce recoveries by 10%: AAAsf / AA+sf / Asf / BBBsf / BBsf / below Bsf Reduce recoveries by 25%: AAAsf / AA+sf / Asf / BBBsf / BBsf / below Bsf Reduce recoveries by 50%: AAAsf / AA+sf / Asf / BBBsf / BBsf / below Bsf Impact on note ratings of multiple factors: Current rating: AAAsf / AA+sf / Asf / BBBsf / BBsf / Bsf Increase defaults by 10%; reduce recoveries by 10%: AAAsf / AA+sf / Asf / BBBsf / BBsf / below Bsf Increase defaults by 25%; reduce recoveries by 25%: AAAsf / AAsf / A-sf / BBB-sf / B+sf / below Bsf Increase defaults by 50%; reduce recoveries by 50%: AA+sf / A+sf / BBBsf / BB-sf / below Bsf / below Bsf SPARKZ 2 Downgrade Sensitivity: Class A1-a / A1-x / B / C / D / E / F Impact on note ratings of increased defaults: Current rating: AAAsf / AAAsf / AA+sf / A+sf / BBB+sf / BB+sf / B+sf Increase defaults by 10%: AAAsf / AAAsf / AAsf / Asf / BBBsf / BB-sf / below Bsf Increase defaults by 25%: AA+sf / AAAsf / A+sf / A-sf / BB+sf / B+sf / below Bsf Increase defaults by 50%: AA-sf / AAAsf / Asf / BBBsf / BB-sf / below Bsf / below Bsf Impact on note ratings of decreased recoveries: Current rating: AAAsf / AAAsf / AA+sf / A+sf / BBB+sf / BB+sf / B+sf Reduce recoveries by 10%: AAAsf / AAAsf / AA+sf / A+sf / BBBsf / BBsf / below Bsf Reduce recoveries by 25%: AAAsf / AAAsf / AA+sf / A+sf / BBBsf / BBsf / below Bsf Reduce recoveries by 50%: AAAsf / AAAsf / AA+sf / Asf / BBBsf / BBsf / below Bsf Impact on note ratings of multiple factors: Current rating: AAAsf / AAAsf / AA+sf / A+sf / BBB+sf / BB+sf / B+sf Increase defaults by 10%; reduce recoveries by 10%: AAAsf / AAAsf / AAsf / Asf / BBB-sf / BB-sf / below Bsf Increase defaults by 25%; reduce recoveries by 25%: AA+sf / AAAsf / A+sf / BBB+sf / BB+sf / Bsf / below Bsf Increase defaults by 50%; reduce recoveries by 50%: AA-sf / AAAsf / A-sf / BBB-sf / B+sf / below Bsf / below Bsf Coronavirus Downside Scenario Sensitivity: Fitch has added a coronavirus downside sensitivity analysis that contemplates a more severe and prolonged economic stress caused by a re-emergence of infections in major economies and no meaningful recovery until around the middle of the decade. Under this more severe scenario, Fitch tested an increased WA default base case of 9.7% as well as lower WA base case recoveries of 15.5% (multiple factors). This compares with default and recovery base cases of 7.3% and 17.2%, respectively in the baseline scenario. The 'AAAsf' default multiple is reduced to 3.3x, compared with 4.0x in the baseline scenario, to reflect the higher degree of stress already included in the base case, while the 'AAAsf' recovery haircut is also reduced to 53.5%, from 55.8% in the baseline. Nevertheless, in this downside scenario we still model a material uplift even in 'AAAsf' default rates. SPARKZ 1 Impact on note ratings of multiple factors: Class A1-a / B / C / D / E / F Current rating: AAAsf / AA+sf / Asf / BBBsf / BBsf / Bsf Downside scenario: AAAsf / AA+sf / A-sf / BBB-sf / Bsf / below Bsf SPARKZ 2 Impact on note ratings of multiple factors: Class A1-a / A1-x / B / C / D / E / F Current rating: AAAsf / AAAsf / AA+sf / A+sf / BBB+sf / BB+sf / B+sf Downside scenario: AAAsf / AAAsf / AA-sf / A-sf / BB+sf / Bsf / below Bsf Best/Worst Case Rating Scenario International scale credit ratings of Structured Finance transactions have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of seven notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of seven notches over three years. The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from 'AAAsf' to 'Dsf'. Best- and worst-case scenario credit ratings are based on historical performance. For more information about the methodology used to determine sector-specific best- and worst-case scenario credit ratings, visit https://www.fitchratings.com/site/re/10111579. USE OF THIRD PARTY DUE DILIGENCE PURSUANT TO SEC RULE 17G -10 Form ABS Due Diligence-15E was not provided to, or reviewed by, Fitch in relation to this rating action. DATA ADEQUACY Fitch has checked the consistency and plausibility of the information it has received about the performance of the asset pools and the transactions. There were no findings that were material to this analysis. Fitch has not reviewed the results of any third-party assessment of the asset portfolio information as part of its ongoing monitoring. Prior to the transactions closing, Fitch sought to receive a third-party assessment conducted on the asset portfolio information, but none was available to Fitch for these transactions. As part of its ongoing monitoring, Fitch reviewed a small targeted sample of Pepper's origination files and found the information contained in the reviewed files to be adequately consistent with the originator's policies and practices and the other information provided to the agency about the asset portfolio. Overall, Fitch's assessment of the asset pool information relied upon for the agency's rating analysis, according to its applicable rating methodologies, indicates that it is adequately reliable. REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING The principal sources of information used in the analysis are described in the Applicable Criteria. The issuer has informed Fitch that not all relevant underlying information used in the analysis of the rated notes is public. ESG Considerations The highest level of ESG credit relevance, if present, is a score of 3. This means ESG issues are credit-neutral or have only a minimal credit impact on the entity(ies), either due to their nature or to the way in which they are being managed by the entity(ies). For more information on Fitch's ESG Relevance Scores, visit www.fitchratings.com/esg. Contacts: Surveillance Rating Analyst Bradley Isaac, Senior Analyst +61 2 8256 0306 Fitch Australia Pty Ltd Suite 15.01, Level 15 135 King Street Sydney 2000 Committee Chairperson Natasha Vojvodic, Senior Director +61 2 8256 0350 Media Relations: Peter Hoflich, Singapore, Tel: +65 6796 7229, Email: peter.hoflich@thefitchgroup.com Leslie Tan, Singapore, Tel: +65 6796 7234, Email: leslie.tan@thefitchgroup.com Additional information is available on www.fitchratings.com Applicable Criteria Consumer ABS Rating Criteria (pub. 09 Jun 2020) (including rating assumption sensitivity) (https://www.fitchratings.com/site/re/10124893) Fitch Ratings Interest Rate Stress Assumptions for Structured Finance and Covered Bonds (Excel) (pub. 06 Dec 2019) (https://www.fitchratings.com/site/re/10104368) Global Structured Finance Rating Criteria (pub. 17 Jun 2020) (including rating assumption sensitivity) (https://www.fitchratings.com/site/re/10126475) Structured Finance and Covered Bonds Counterparty Rating Criteria (pub. 29 Jan 2020) (https://www.fitchratings.com/site/re/10108544) Structured Finance and Covered Bonds Counterparty Rating Criteria: Derivative Addendum (pub. 29 Jan 2020) (https://www.fitchratings.com/site/re/10108546) Structured Finance and Covered Bonds Interest Rate Stresses Rating Criteria (pub. 06 Dec 2019) (https://www.fitchratings.com/site/re/10103887) Applicable Model Numbers in parentheses accompanying applicable model(s) contain hyperlinks to criteria providing description of model(s). 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