11/30/2012

Nervousness Creeps Into Subprime Auto Sector

Has the subprime auto-loan boom run its course?

As the amount of financing extended to buyers with spotty credit histories has exploded in recent years, lenders in the sector have sought to sustain that growth by relaxing the minimum credit-quality standards for borrowers. The result has been a gradual weakening of loan performance that some now view as evidence of a coming down cycle.

They envision a scenario in which losses among certain originators’ asset pools would exceed limits set by warehouse lenders, causing them to lose access to some or all of that financing. Without the ability to accumulate loans, those shops also would find themselves locked out of the asset-backed bond market — putting them at risk of failure. “I can’t dispute the fact there will be a casualty or two,” one issuer said. “There are a lot of lenders, even big ones, that are growing like crazy putting a ot of garbage on the books.”

Few dispute the idea that losses will continue to rise. The question is when, or if, loan performance will weaken to a point that warehouse lenders find intolerable.

For many subprime auto lenders, access to warehouse financing automatically begins to shut down when losses reach 8-10%. According to an index maintained by Fitch, average annual losses among securitized pools of subprime car loans have climbed for five straight months, from an average of 3.76% in May to 6.44% in October — a trajectory that worries many industry professionals.

Declining credit quality for 2011-2012 vintage loans is the clear culprit. After losses maxed out around 8-9% during the financial crisis, lenders adopted ultra-conservative underwriting standards that resulted in stellar performance for loans printed in 2009-2010. From there, average FICO scores gradually dropped as larger lenders sought to increase their origination volume and newly established shops faced pressure from private equity backers to grow at a rapid clip.

Take Capital One, which lowered its minimum FICO score to 520 from 540 this year. Ally Bank has made a similar adjustment, while Banco Santander and General Motors Financial have moved slightly down the credit scale.

At the same time, capital has flooded into smaller shops from buyout specialists including Blackstone, Fortress Investment and Perella Weinberg Partners — enabling some of the recipients of that backing to double or even triple their lending volume. While those outfits’ lending standards are harder to peg, the competition they present is evident. For example, Exeter Finance emerged as one of the fastest-growing players in the field after receiving nearly $1 billion of financing from Blackstone in August 2011. The Irving, Texas, lender made its first appearance as an asset-backed bond issuer this year, placing $500 million of bonds in two transactions.

So who is most at risk? While it likely will be business as usual for well-established shops, small players appear to be the most vulnerable to a performance-induced loss of funding. That’s because many market newcomers don’t have well-established loan-collection processes. “The biggest challenge for new folks is the servicing side,” one issuer said. “There are a lot of smaller firms that don’t have the scale from a servicing perspective, and it’s more expensive for them in general. Compound that with poor loan performance, and it becomes more difficult.”

In fact, some of the largest lenders could even seize on opportunities to buy servicing assignments and loan portfolios from smaller counterparts that run into trouble.

Another way that weakening loan performance could play out: Asset-backed bond investors might punish more-aggressive lenders by demanding higher yields, forcing those shops to reduce their reliance on weaker borrowers to fuel growth. The result would be reversal of the sector’s expansion. “The market is pretty saturated now with subprime lenders . . . if the credit quality decreases some will walk away, but others will just demand more yield,” one source said.

Or, as another source put it, “those performance issues are real and will have a systemic impact on the industry by increasing spreads and ultimately causing newer issuers to tighten standards.”

There already may be some signs of waning demand. A $1 billion deal that GM Financial’s AmeriCredit Financial unit priced on Nov. 15 included a one-year slice of triple-A-rated notes that went at 20 bp over eurodollar futures. That was 8 bp wider than a similar batch of bonds the company sold Sept. 5. That said, the pricing also was well tighter than comparable securities placed by United Auto Credit and Westlake Financial — deals that industry participants cited as signs of health for the market.

Worries of a potential implosion contrast with a buoyant tone that has prevailed as the subprime auto loan industry emerged as an area of particular strength in the wake of the financial crisis. Lending growth has been mirrored in securitization volume, with 30 deals totaling $16.9 billion completed so far this year. That’s up from $12.6 billion in 2011, $8.2 billion in 2010 and just $2.5 billion in 2009, according to Asset-Backed Alert’s ABS database. ?

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