Investors, driven to near insanity by the Fed’s interest rate repression, have developed an insatiable lust for structured securities backed by subprime auto loans.
Mind you, these are not high-risk securities, as you might be misled to imagine from the name “subprime”; many of them are triple-A rated by none other than venerable Standard & Poor’s, which agreed in early February to pay $1.375 billion to settle with the Department of Justice and 19 state agencies the allegations that it “had engaged in a scheme to defraud investors in structured financial products,” namely slapping triple-A ratings on toxic Mortgage-Backed Securities and Collateralized Debt Obligations in the run-up to the Financial Crisis.
OK, today’s subprime securitization rage is in the auto-loan sector, not mortgages. About 31% of all outstanding auto loan balances are rated subprime. They’re the foundation of booming auto sales. There is a lot to securitize. It’s so hot that private-equity firms are all over it. And IPOs are flying off the shelf.
These auto lenders – from giants such as Ally and GM Financial to smaller ones – are under investigation by the DOJ and a laundry list of other federal and state agencies for the underwriting criteria they used on securitized subprime auto loans as well as the representations and warranties related to these securitizations.
But this isn’t curtailing investors’ insatiable lust for these highly-rated low-risk products, and subprime lenders keep pushing them out the door.
Santander Consumer USA, and one of the targets of the DOJ investigation, is planning a $1 billion securitization of subprime auto loans. It already issued two securitizations since the DOJ subpoenas last summer, no problem. A $434-million slice of the current deal is rated triple-A by S&P.
In 2011, private-equity firms Kohlberg Kravis Roberts, Centerbridge Partners, and Warburg Pincus bought a 25% stake in the unit from Banco Santander in Spain. In January, they all cashed out part of their investment by selling 75 million shares to the public at $24 a share, raising $1.8 billion in the IPO. Banco Santander sold a 4% stake for a net gain of $1 billion, Bloomberg reported. It still owns 61% of the unit. The PE firms pocketed a partly realized gain of at least 133% on their $1 billion equity investment, including $257 million in cash dividends.
The public wasn’t so lucky. The shares closed on Friday at $22.88, down 4.6% from their IPO price.
Also this week, DriveTime Automotive Group sold $265 million in structured securities based on subprime auto loans, according to Structured Finance News. In November, it had settled with the Consumer Financial Protection Bureau (CFPB) by agreeing to pay $8 million and changing its debt collection practices, such as not calling delinquent borrowers at work after being told not to.
DriveTime is a privately-held used-vehicle retailer with 126 dealerships across the US, focused on “deep subprime” – consumers with a FICO score of less than 550. About 20% of its customers don’t even have a FICO score. It finances its sales in house and then securitizes the loans.
In its securitization pool this week, 86.3% are loans with terms of 61 months or more, which are riskier than shorter-term loans. A $130-million slice was triple-A rated by S&P, another slice was double-A rated, and the third slice was single-A rated. Risks and investigations, no problem.
Also this week, subprime auto lender CarFinance sold $266 million in structured securities. The least risky slice carried S&P’s single-A rating. Other slices were rated as low as “BB-.” The underlying loans have an average FICO score of 603, pay an annual interest rate of 15%, have a term of 72 months, and sport an average loan-to-value ratio of a dizzying 118%.
In the zero interest rate environment imposed by the Fed, investors go for anything that has a discernible yield.
Private equity firm Perella Weinberg Partners established CarFinance in 2011. Since then, its portfolio has ballooned to $716 million. Last month, Perella merged it with its other subprime auto-loan outfit, Flagship Credit Acceptance. Combined, they originate about $1.2 billion in subprime auto loans a year.
But it’s not easy to make money in this business. Subprime auto lender Exeter Finance, which PE firm Blackstone Group bought in 2011, exploded its portfolio from $150 million to $2.8 billion in three years. It has now become America’s third-largest issuer of subprime auto-loan structured securities. It too received subpoenas from the DOJ and other agencies. And it has been losing money for three years.
American Banker took a look at a $500-million securitization the company sold last August and found a doozie:
The average APR on those loans was 18.59%. The original term length was 70 months. 75% of these loans had a loan-to-value ratio of over 105%. Eighty-one percent of the borrowers had a FICO score of below 600. And yet some of the securities that these loans are turned into are rated AAA.
Given the hoopla surrounding subprime, American Banker asked Exeter’s new CEO Thomas Anderson if he was thinking about an IPO (despite the losses). “I think it’s probably unlikely in ’15, but I wouldn’t rule it out,” he said.
And has the regulatory scrutiny led to changes inside the company? Well, “probably the only real meaningful, tangible difference is it’s led us to have kind of more people in, I’ll call it the legal department….”
But it has not had any impact on investor enthusiasm, “at least to date,” Anderson said.
Subprime loans allow the over-indebted, under-paid middle class, the new American proletariat, to buy a car without which they couldn’t go to work, go to the grocery store, or take their kids to the doctor. But these folks are sitting ducks for the industry. Thinking they have no options, they get pushed into overpriced vehicles and – what makes investors’ mouth water – expensive loans.
In face of this boundless investor enthusiasm and blindness to risks, Equifax, which makes its money selling the data it collects on consumers, came out swinging in defense of subprime.
Consumers with deep-subprime FICO scores on average improve their scores after they buy a car and make payments regularly, it said. They come out of their subprime loan in better shape than they went into it. It didn’t mention the consumers who default on their usurious subprime loans; they get whacked.
Equifax complained that subprime auto loans were “an all too easy target these days, “that the increased negative media focus on some worst-case scenario situations has drawn criticism to an industry that – rather than a pointed finger – deserves some recognition for weathering the storm of the Great Recession, and ultimately helping to pave the way for our recent economic recovery.”
It said point-blank, “The Subprime Auto Bubble is Fiction, Not Fact.”
And not a word about the securitization boom and that is stuffing these sliced and diced and repacked triple-A rated subprime loans into bond funds of unsuspecting conservative investors – because that’s where most of these things end up, and that’s where they can quietly decompose.
New vehicle sales in the US could hit 17 million in 2015, everyone believes. The glory days are back, thanks to subprime. The industry is drunk with its own enthusiasm. Read… Subprime Spikes Auto Sales, Delinquencies Soar, Industry in Total Denial, Fallout to Hit Main Street