Deals by first-time issuers of subprime ABS are wildly oversubscribed, the credit quality of the underlying assets is deteriorating, profit-hungry investment firms are buying stakes in issuers, and financing costs look to hold at record lows for the indefinite future.
Sound like a recipe for trouble, or a strong buying opportunity?
The answer appears to be both. There's no doubt that the broader ABS market is heating up. For the year to date through March 21, there has been $35.2 billion of ABS issuance, nearly two thirds of it, or $22.8 billion, auto ABS, according to data compiled by Credit Suisse. That compares with $21.1 billion of ABS for the same period of 2011 and $111.2 billion for all of last year.
There were nine subprime auto deals during that period totaling around $4.2 billion, according to the ASR Scorecards database. Issuers of private-label credit card and student loan issuers, which include loans to subprime borrowers, also completed more than half a dozen successful deals.
Many of those offerings, prime and subprime, were either upsized, oversubscribed, or both. Among subprime auto lenders, Santander Consumer USA's, a long-time ABS issuer, first two transactions in 2012 were upsized. Meanwhile, Exeter Finance Corp. saw its inaugural $200 million transaction oversubscribed by nearly three times in late February.
The most important driver of the issuance uptick - still on a miniature scale compared with the heyday of pre-financial crisis years - has been record low yields across the investment spectrum that have pushed investors to search for additional spread.
"Everybody in this environment has been very challenged to get the kind of bonds and exposures we would like," said Jon Thompson, vice president of structured finance at Advantus Capital. He added that the premiums offered by subprime ABS appear to have drawn new investors to the market.
Mark Floyd, CEO and vice chairman of auto issuer Exeter, said he has spoken with numerous institutional investors who are new to the subprime auto market and are attracted to the asset class because of its relatively strong performance through the financial crisis and current spread premiums. "We've talked to a number of people kicking the tires," he said.
The low yields are the result of federal policy makers seeking to revive investors' appetite for risk to fuel increased economic growth. "The main factor is the [Federal Reserve] providing abundant liquidity in the market and keeping rates low on the front end [of the yield curve] on an absolute basis," said James Grady, head of structured finance at Deutsche Insurance Asset Management. "The game plan is to force investors to take credit risk and duration risk, and for those unwilling to take duration risk, then more credit risk."
Grady said that while the ABS market is still in the early stages of the credit cycle, there have been a "plethora" of issues from "off-the-run" or smaller issuers that are taking advantage of investors' demand for yield. He added that the last time the Fed pursued a similar strategy of holding rates down, between 2004 and 2006, "It didn't end too well, and chances are this time it won't end well either."
Moody's Investors Service has expressed similar concerns. In a March 15 report, the rating agency pointed to several trends suggesting that risk is increasing, including originators easing underwriting standards, untested and nontraditional issuers, assets and capital entering the market and the reappearance of structural features increasing risk.
An example of the latter, Moody's said, is the reemergence of prefunding accounts, which are cash reserve funds to purchase assets after a deal closes. Such accounts increase the risk that assets delivered to the trust will be of lower credit quality and result in negative carry when the sponsor does not deliver new assets to the trust and the interest on the cash is less than the interest owed on the ABS bonds. The agency cited 2011 and 2012 vintage subprime auto transactions as well as some 2009 vintage private student loan securitizations as examples of the reemergence of prefunding accounts.
Yan Yan, a senior analyst at Moody's focusing on auto loans, said there is also anecdotal evidence suggesting that auto ABS may be well into its credit cycle. She said that while Moody's coverage of subprime auto loan issuers has been limited because of concerns about the operational risks of some recent niche and smaller issuers, the rating agency nevertheless has maintained an open dialogue with most of them.
"They say we're about 70% there, in terms of competitiveness in the [auto] industry" and terms loosening up before they begin tightening again, Yan said.
The question then becomes when the 100% mark arrives. Grady said that, while deals backed by higher-risk assets are outperforming now, the cracks will likely begin to show once investor liquidity drops and they distinguish more carefully between strong and weak assets. "A lot of it comes down to timeframe. In the short term, these [subprime] deals are likely to outperform, but over the longer term they've shown themselves to be more volatile and riskier than the more regular, stronger names," Grady noted. "The question is will people be able to sell out of those names before the turn in the credit cycle?"
Moody's, like the other credit rating agencies, expresses confidence in its own ratings process and its ability to adjust for lower credit-quality standards by, for example, requiring greater credit enhancement to maintain high ratings. That does not stop the agencies from engaging in finger pointing, however. In its March report, Moody's said that "some recent cases have come to market for which we believe increased risk has not been adequately mitigated for the level of ratings assigned by another agency. These transactions typically involve smaller, less experienced and less well-capitalized originators and servicers."
The report specifically cited Exeter Finance, noting that its recent ABS offering had received high investment-grade ratings from two other rating agencies. It described Exeter, which Moody's does not currently rate, as small with limited asset performance history, resulting in a potential "for volatility in asset performance" that "makes high investment-grade ratings inappropriate."
In fact, Exeter's bonds were rated 'AAA' by DBRS and a notch lower by Standard & Poor's; the latter's presale report listed similar reasons for its lower credit rating, including "the fact that the company is not profitable yet, has a relatively short performance history (3.5 years) compared to its peer companies and that the company, itself, doesn't have a securitization track record."
Other types of loans to borrowers with less-than-pristine credit that might end up in securitizations, such as credit cards and student loans, are also showing credit-quality slippage. For example, Moody's said, banks' credit card solicitations nearly doubled in 2011 compared with the previous year. The agency noted that credit quality has dropped since the vintages originated in 2009 and 2010, although it remains higher than the years before the credit crisis. Total originations were up 22%, but among new accounts with credit scores over 700 the increase was only 13%, while accounts with scores below 620 were up 40%.
Specialty finance companies like Exeter tend to securitize these loans quickly because it is their main source of financing. The decision to securitize would depend on the state of the market at any given time. On the other hand, banks currently have a lot of capital and spreads on subprime-type loans are ideal, so they're holding a lot of this stuff on their books.
Moody's said the increase in lower credit-quality originations has yet to impact ABS performance because most banks have not included those accounts in their trusts.
"Whether banks will find it economically attractive to add these accounts to existing trusts in the future is not clear at this time," the Moody's report said. Issuance of credit card ABS reached $5.5 billion as of March 21, according to Credit Suisse, an increase of 71.9% over $3.2 billion for the same period of 2011.
Michael Binz, head of ABS ratings at S&P, said that among the three traditional ABS asset classes, there's more concern currently about student loan deals.
"Our outlook there continues to be more negative. We've had some negative ratings actions in that space, typically for transactions completed prior to the financial crisis," Binz said. "In more recent transactions, we've looked for higher credit enhancement and stronger structures."
Binz noted that the major hurdle facing SLABS is the dismal job outlook for recent graduates. Concerns about the future of subprime SLABS may lessen, however, if the economy and jobs outlook continues to improve. In fact, bright economic prospects appear to be one factor behind the increase in ABS issuance.
Chandra Bhattacharya, head of ABS and non-agency MBS strategy at Credit Suisse, said investors are currently engaged in a "risk-on" trade and piling into relatively riskier assets. "As we've seen better economic data in the last months, investors are taking on more risk and chasing yields, thinking the economy is improving," Bhattacharya said.
Bhattacharya said he predicted late last year that as the unemployment rate stabilized and improved, private SLABS would likely see spreads tighten, and indeed that occurred across most prime and subprime ABS. Another factor tightening spreads, according to Bhattacharya, is that because borrowers' need for credit is less as they continue to deleverage, net new issuance is insufficient to replace maturing securities, creating a shortage of supply and negative net new issuance in all but the more esoteric ABS.
Tighter spreads reduce returns for investors but have had little impact on the credit quality of the bonds. Bhattacharya said underwriting standards remain tight. More worrisome underwriting standards on the subprime side, he added, are generally preceded by strong demand for loans on the primary side and lenders competing for business by making credit more easily available, and there's no indications now of that happening.
Floyd, Exeter's CEO, said that auto lenders are increasingly competing on the rates they offer borrowers. He added that the dealers from which his firm buys loans are seeing increased but still limited demand from subprime borrowers, indicating a slowly growing economy. That limited demand means lenders are aren't stepping down the credit-quality ladder in search of loans to put in their securitization pools. "As long as we don't see lenders chasing each other down the credit stack, it's good for the industry," said Floyd, who, along with several of Exeter's top management, moved over from AmeriCredit, a major player in the subprime space that was acquired by GM Financial in 2010.
Consumer Portfolio Services and 1st Investors Financial Services are subprime lenders in business since the early 1990s that have also issued ABS this year, and banks noted rumors that similar long-time players as well as relatively new lenders are likely to issue ABS in the coming months. That will turn the heat up under subprime lenders, of which some, like Exeter, are at least partially owned by nontraditional participants in the subprime auto market, including private-equity fund sand hedge funds.
Moody's cited the rich returns those types of investors seek, pushing subprime lenders to grow rapidly, as potentially another cause for concern. Floyd said Exeter will compete on price, but if competition becomes too aggressive - a scenario it has discussed with its owner, private equity firm Blackstone - it will back off rather than get into pricing wars with competing lenders.
"There will be times when we'll have to take it a little slower because competition is not letting us get the returns we've targeted," Floyd said, adding that being owned by Blackstone has enabled the lender to establish alternative funding if the ABS market dries up.
"We've made sure we have plenty of warehouse capacity. With Blackstone and our bank partners, we have capacity to originate loans through a slow-down or tightening of the capital markets for six months or a year," Floyd said, noting that the firm has put in place a $600 million line of credit through four banks.
Floyd said Exeter plans to become a regular ABS issuer, likely coming to market later this year with at least one more, somewhat larger deal, and issuing quarterly thereafter.
The performance of subprime ABS, from auto to student loans, will clearly depend in part on the outlook for the economy and on the labor market.
Even if the economy turns south, however, subprime auto ABS may be among the safest investments around.
Binz at S&P noted that only two of the subprime auto deals it has rated over the last 20 years defaulted, and they were both rated 'BB'. The loan vintages following the financial crisis, he added, are very strong from a credit standpoint, noting that loan-to-value ratios in 2007 were 120% and dropped to 111.9% in 2010. Exeter's LTV was 111%, he said.
Current external factors are also providing strong tailwinds to recent vintages.
For example, increased credit enhancement has become imperative for newly issued subprime ABS since the financial crisis, and record low funding costs have further bolstered that enhancement. For subprime auto loans, Bhattacharya said, borrowing rates have remained fairly stable over the last few years at 17% or 18%, while funding costs are at record lows.
As long as deals are structured so that excess spread is retained in a reserve account, "the structures are increasingly protected because they have so much excess coupon available," he said, adding, "We believe prime and subprime auto ABS are going to do exceptionally well, and even if credit quality drops from 'AAA' to 'AA,' they'll do quite well."
Melinda Zabritski, director of automotive credit at consumer credit-rating provider Experian Financial Solutions, agreed that the terms on subprime loans were loosening. Maturities are being extended somewhat and average credit scores have fallen year over year, although not by much.
However, even if cars are repossessed, the severity of losses on the loans is quite low, she said, because prices in the used-car market remain high. As the credit cycle turns, loan credit quality is bound to deteriorate and delinquencies rise, but loans supporting subprime ABS, at least in the auto sector, should remain strong.
"I wouldn't be surprised if we started to see a year-over-year uptick in delinquencies toward the end of this year, but I don't think it's going to be anything dramatic," Zabritski said.