Tags: Subprime | Auto Debt | Loans | Credit

What Lurks in Subprime Auto Debt Is Anybody's Guess

Thursday, 02 Oct 2014 10:50 AM

The U.S. housing crisis laid bare an epidemic of fraud and sloppy paperwork on loans made to home buyers with spotty credit. For those who bought bonds backed by the mortgages, it fueled at least $250 billion of losses.

Six years later, investors are snapping up a new crop of subprime bonds, this one backed by auto loans. Ratings companies are awarding top grades to the securities, and buyers have almost no way to determine the accuracy of the information they get about them.

Now, the market’s drawing scrutiny as the U.S. Justice Department probes underwriting and disclosure practices and the U.S. Securities and Exchange Commission seeks to ensure investors get adequate information.

“Investors are basically taking the issuer’s word that they follow certain procedures, and there is opportunity for fraud,” said Eugene Grinberg, a former analyst who structured subprime auto asset-backed bonds before co-founding Rockville Centre, New York-based market software firm Solve Advisors.

The securities are fueling much of the 72 percent surge in annual auto sales since 2008 as near-zero interest rates lure both borrowers and lenders looking for higher-yielding assets.

IHS Automotive raised its light-vehicle sales forecast to 16.4 million this year, the most since 2006, as credit to buy cars becomes easier to obtain. Auto debt outstanding rose to a record $919 billion at the end of June, according to Federal Reserve data compiled by Bloomberg.

Shelved Plans

While the $168.3 billion market for bonds backed by car loans is a fraction of the $3 trillion of securities Wall Street created from mortgages in the three years before the financial crisis, investors in home-loan bonds get more information on the underlying debt.

Ratings firms also now seek reviews from third parties to verify things like borrowers’ income and property appraisals before they’ll stamp their grades on mortgage notes.

The SEC in August approved expanding disclosure for publicly registered asset-backed securities including auto debt. However, it shelved a proposal to extend that to private deals that are often issued by market newcomers. For public deals, the regulator reduced the amount of information it demands to 72 data points from 110 proposed in 2010. A borrower’s employment is required, for example, but the rules don’t obligate lenders to disclose the same information for a second borrower such as a spouse.

Little Transparency

The scaled-back rules mean that large swaths of bonds sold by subprime lenders from Blackstone Group LP’s Exeter Finance Corp. to Perella Weinberg Partners’s CarFinance Capital LLC can be sold to investors who receive only broad data such as aggregate credit scores. Even for public securities sold by companies including the finance arm of General Motors Co., the information won’t need to be verified by third parties.

“Due diligence hasn’t changed much since the crisis,” said John Griffin, a finance professor at the University of Texas at Austin. Investors are still at risk from “the lack of transparency.”

By contrast, investors in mortgage bonds typically have access to spreadsheets with dozens of details on each loan, ranging from the appraised value of a property to a borrower’s salary and employment history. They get the data after it’s been reviewed by a third party.

Sales Pressure

Auto lenders collect less information on borrowers compared with mortgages because dealers want buyers to be able to drive off the lot that day, according to Ben Diehl, an attorney at Stroock & Stroock & Lavan LLP.

“There’s a real pressure to sell more product,” said Chris Kukla, an attorney at the Center for Responsible Lending in Washington. “This is a sector of the economy that hasn’t seen much regulatory attention at all.”

Investors are still reliant on credit-ratings firms to put their stamps of approval on bonds where each deal may be backed by tens of thousands of loans, compared with several hundred to a few thousand in mortgage securities.

Standard & Poor’s leads ratings companies by providing grades to almost 80 percent of subprime auto-loan securities issued through Sept. 17, followed by Moody’s Investors Service at 53 percent and Fitch Ratings’s 29 percent, according to industry newsletter Asset-Backed Alert. DBRS Ltd. has assigned grades to 26 percent, while Kroll Bond Rating Agency Inc. handled 8 percent.

Vetting Lenders

“For the few subprime auto transactions that we rate, the lenders’ long track history and very granular nature of the pools has mitigated the need for additional detailed file reviews or third-party due diligence,” John Bella, a managing director for structured finance at Fitch, said in a statement.

Fitch will monitor regulatory probes “to determine whether expanded loan-file reviews or third-party due diligence are warranted,” he said.

Moody’s also uses the issuers’ historical data and the role of the deal’s sponsor “to ensure the accuracy of the data,” Tom Lemmon, a spokesman for the New York-based ratings firm said in an e-mailed statement.

S&P caps its ratings on companies with short histories, if it offers grades on those securities at all, Ed Sweeney, a spokesman for the unit of McGraw Hill Financial Inc., said in a statement. The firm also has taken steps to increase loss cushions in subprime bonds it rates as credit quality has deteriorated, he said.

Homogeneous Terms


DBRS won’t rate and discontinues outstanding ratings “in any situation where there is a lack of reliable data,” said Chuck Weilamann, senior vice president of structured finance at the Toronto-based firm. Kroll reviews the practices of the bond issuers and the ratings reflect representations and warranties those firms make that they’re following laws and industry standards, Kim Diamond, head of structured finance at the firm, said in a statement.

“With thousands of loans with relatively homogeneous terms and short durations, KBRA has determined there is sufficient data to support the ratings that have been assigned,” she said, referring to Kroll by its acronym.

Investment firms from Blackstone to Perella Weinberg have jumped into the market to capitalize on the growth. Blackstone, the private-equity firm run by billionaire Stephen Schwarzman, acquired Irving, Texas-based subprime lender Exeter in 2011, the same year that Perella Weinberg partnered with CarFinance.

Delinquencies Rising

Meredith Fletcher, a spokeswoman at Fletcher PR for Exeter, declined to comment, as did Crystal Hartwell, a spokeswoman at mWEBB Communication for CarFinance.

Scrutiny is growing as subprime auto payments more than 60 days late climbed to 3.63 percent of the debt outstanding in July, from 3 percent a year earlier, S&P said in a Sept. 18 report, citing the latest available statistics.

The Justice Department is investigating the quality of the loans, sending subpoenas to GM’s finance unit and to Santander Consumer USA in the last two months. It’s seeking documents relating to the securitization of the loans, the underwriting criteria used to make the loans and contractual promises made about their quality, according to company filings.

Judith Burns, a spokeswoman for the SEC in Washington, declined to comment, as did Laurie Kight, a spokeswoman for Santander Consumer USA, Chrissy Heinke, a spokeswoman at GM Financial and Nicole Navas at the Justice Department.

Yield Hunt

Lenders have a ready supply of funds, thanks to bond investors who are seeking securities with relatively high yields as the Fed keeps benchmark interest rates near zero for a sixth year. Top-ranked securities linked to subprime auto loans are yielding 0.44 percentage point more than benchmark rates, according to Wells Fargo & Co.

Wall Street sold $17.7 billion of the bonds through Sept. 26, a pace that would make 2014 the busiest year since 2006, according to Barclays Plc. GM Financial issued $1.2 billion of securities in June backed by 63,045 car loans. Moody’s and Fitch gave AAA ratings to $767 million of the bonds, which pay a floating rate starting as high as 0.94 percent.

In a prospectus for the bonds, investors who bought them were given no details on individual loans. The most specific data shows that 48 percent of the money lent was to borrowers with credit scores from 540 to 599, below the 620 level often considered the start of subprime rankings, while another 29 percent had lower grades. The document doesn’t explain how many of the weakest creditors were borrowing more than the value of the cars. A total of 73 percent of the loans are greater than the stated values of the vehicles.

Buying Ratings

“The investors don’t care; They’re buying the rating,” said William Harrington, a former analyst with Moody’s. “They’re getting a higher yield and are happy with that.”

Less than a month after disclosing its federal subpoena, Santander Consumer USA was preparing to sell $1.1 billion of bonds tied to subprime auto loans.

Demand was so great that it boosted the size to $1.3 billion and investors accepted lower yields than initially offered. Santander issued securities rated AA by S&P to pay 0.85 percentage point more than benchmark rates after marketing the debt at a spread of 0.95 percentage point.

Buyers and ratings firms have several methods for scrutinizing the deals, said Darrin Clough, a senior fixed-income analyst at OppenheimerFunds Inc., which oversees about $250 billion.

Fraudulent Mortgages

In addition to looking at their track records, raters and investors scrutinize the processes used by lenders to evaluate borrowers and car dealers, he said. Issuers also make promises to buy back any debt that has been misrepresented and retain the pieces of the bond deals that are in line to take losses first.

“Any underperformance as a result of bad data or underwriting would be borne by them first,” Clough said.

That type of safety net failed to prevent investor losses after the collapse of the housing market.

Mortgage-bond issuers such as New Century Financial Corp. and American Home Mortgage Investment Corp. went bankrupt before investors could collect on such promises to repurchase bad loans. In a 2007 report by Fitch, the firm cited a study that found as much as 70 percent of mortgages with quick defaults involved fraud or misrepresentation.

Realized losses on subprime mortgages packaged into securities totaled $258 billion from 2006 through 2012, with bonds tied to other risky home loans bringing the tally to $449.4 billion, according to Moody’s Analytics. That doesn’t include additional losses on pending foreclosures.

Safe Investing

First Pacific Advisors LLC is buying some of the safest portions of auto-loan bonds deals while avoiding riskier ones, said Abhi Patwardhan, a senior vice president at the Los Angeles-based firm.

Much of the highest-rated debt could survive losses of 50 percent or more on the underlying loans, said Patwardhan, whose colleagues Robert Rodriguez and Thomas Atteberry were named Morningstar Inc.’s fixed-income managers of the year in 2008 after recognizing the dangers lurking in the mortgage market.

“In respect to the AAA tranches, I feel fine,” Patwardhan said in a telephone interview.

“Every issuer we invest with, we try to get comfort that they’re verifying” that the data provided is accurate. “I’m not confident all of the ones that we don’t invest with do.”

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The U.S. housing crisis laid bare an epidemic of fraud and sloppy paperwork on loans made to home buyers with spotty credit. For those who bought bonds backed by the mortgages, it fueled at least $250 billion of losses.
Subprime, Auto Debt, Loans, Credit
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2014-50-02
Thursday, 02 Oct 2014 10:50 AM
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