Credit Cracks

Over the past few months, the credit markets have flashed warning signs meriting investor attention. One standout failure, Tricolor Holdings, has raised concern about underwriting, complexity and servicer/asset quality oversight. Tricolor collapsed with allegations of double pledging collateral and weak documentation in its auto loan ABS structure.

While the greater market appears to function as if these events were largely idiosyncratic, it marks an opportune time to review policies toward risk management in credit portfolios. Jamie Dimon, JPMorgan Chase & Co.’s CEO remarked “when you see one cockroach, there are probably more,” suggesting the potential for further trouble in pockets of credit.

These events underscore that structured products relying on complex collateral, highly proprietary or customized servicing, and rapid growth deserve monitoring. The broader market hasn’t cracked yet, but the highlighted failures mark weak links. For example, the fact that many tranches of Tricolor’s ABS were rated AAA shortly before collapse raises questions around structuring and servicer oversight.

Given the current environment, investors in ABS or structured credit should consider reinforcing their framework around servicers and underlying collateral. Key practices include:

Deep servicer & originator review: Evaluate the servicer’s history: track record in collections, default escalation, transparency, audit/verification of underlying loans/assets. How much “skin in the game,” how aggressive is underwriting, what is the collateral? Are assets verifiable? Is there a backup servicer and are they ‘hot’ or ‘warm’?

Look at transparency of the pool: quality and granularity of loan-level data (borrower credit quality, delinquencies), off-balance sheet structures, receivables financing, etc. Review the nature of the collateral: e.g., auto loans to subprime borrowers, consumer receivables, commercial trade invoices — assess whether borrower default risk and collateral recovery risk are well-modelled. Understand the vehicle structure: par subordination/overcollateralization, waterfall, triggers for credit enhancement.

Stress test for adverse scenarios: rising interest rates, weaker recovery, servicer disruption, borrower behavioral changes. In the event of a servicer disruption, what additional costs might arise from the transfer to backup servicer? Who bears these additional costs?

Impose limits on exposure to any single servicer or originator: no more than X % of ABS portfolio with the same servicer/originator entity, or same collateral type with similar risk profile. Consider capping the total exposure to ‘higher risk’ servicers/originators (those with aggressive growth, less transparency, higher leverage). Recognize that in structured finance, liquidity can evaporate quickly if confidence fails. Build readiness to reduce or exit positions if servicer/originator signals degrade.

Conclusion

The collapse of Tricolor doesn’t necessarily signal a broad systemic failure, but it does serve as an important reminder of structural risk hidden in credit markets. Investors in ABS and structured credit should sharpen their due diligence, especially around servicers, originators and collateral quality, and adopt clear position limits and monitoring frameworks to avoid getting caught off guard.