Subprime auto bonds caught in vise of rising costs, bad loans

Wednesday , March 14, 2018 - 9:36 AM

Adam Tempkin

(c) 2018, Bloomberg.

More Americans are falling behind on their car payments and that’s making it more expensive for subprime auto lenders to sell bundled loans.

On average, AAA bond investors last year demanded insulation from the first 51 percent of losses on subprime-auto asset-backed securities, up more than seven basis points from 2016, according to Wells Fargo. Prime lenders needed to offer enhancements on just 6 percent, Fitch Ratings said.

The demands come as investors have grown weary of a market that’s worsening at the same time that the extra interest offered over safer debt has started to shrink to levels last seen before the financial crisis. Delinquencies have steadily increased over the last five years, according to S&P Global Ratings, with losses rising to 8.32 percent for subprime-auto bonds in 2017 from 8.13 percent in 2016.

The need to boost costly credit enhancements eats away at already-thin profit margins at lenders struggling with deteriorating loan quality. For Joseph Cioffi, a partner at Davis & Gilbert, such a trend may leave the firms at risk if they run into financial trouble or an economic shock weakens borrowers further.

“Credit enhancement could be viewed as a deodorizer for poor quality loans,” he said in an interview. “One method of enhancement is to put excess loans in a deal, but if you have 100 bad loans, and put in 50 more bad loans, you’re not any better off. If there is a shock to the economy that affects consumers generally, then all of the loans could be affected.”

So far, lenders such as Exeter Finance, Foursight Capital and American Credit Acceptance haven’t seen any falloff in demand for the asset-backed securities as long as they add the extra safeguards to attain or bolster AAA ratings on the senior-most portion of the deals.

The protections can include adding more loans to a bundle to pad the interest payments, setting up a subordinated structure where holders of the lowest-rated bonds get hit first and including loans that pay more than the bond itself.

Exeter -- which is backed by Blackstone Group -- got its first AAA rating for a subprime auto ABS in January by boosting its credit enhancement to more than 56 percent for the top-graded tranche. In prior deals, it structured in less protection and was only able to get a AA grade.

Skopos Financial set protection levels for its highest-rated AA slice at more than 58 percent for a “deep-subprime” bond currently being marketed. That’s up from 48.75 percent in a similar 2015 deal that saw early collateral defaults that nearly tripped one of its covenants just months after being issued.

In something of a twist, adding the safeguards has led to rating upgrades for some of the riskiest ABS bundles. That’s because as the cushions get triggered when losses on the junk-rated tranches mount, the issuer is forced to compensate and that increases the overall creditworthiness of the package. And that attracts fresh demand.

While investors seem to have faith that the protections are adequate, their demand for ever more of them shows how difficult the environment has become for lenders as spreads on such securities have tightened -- something that’s only expected to worsen. The AAA slice of a Santander subprime-auto bond priced in mid-February landed at 23 basis points over a benchmark, compared to 35 basis points in a deal from a year earlier.

At the same time, American car buyers don’t seem to be improving their credit profiles even as the economy picks up steam and unemployment falls to multiyear lows. Subprime auto bonds have surpassed the pre-financial crisis peak as a share of the overall auto-ABS market. Last year, the category represented about $25 billion out of total issuance of $110 billion, according to Bloomberg data.

“We’ve seen a rise in delinquencies and losses in some parts of the subprime auto sector; sometimes it’s seasonal,” said Ken Purnell, head of ABS portfolio management at Invesco. “But delinquencies are likely to hit a higher peak this year versus prior years.”

That trend makes it unlikely that the need for enhancements will start to wane as investors continue to seek out AAA-rated subprime loans. That’s a red flag for Cioffi.

“A lot of people are putting faith in credit ratings again, as well as in credit enhancements, and relying on the agencies to kick the tires,” he said. “But what is faith? It’s the absence of facts.”


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