Credit enhancement can't cure all ills in subprime auto market
Over the past couple of years, subprime auto lenders have been able to offload more and more of the risk in their loans to investors desperate for higher yields.
Despite the high rate of default among borrowers with poor credit, investors are snapping up billions of dollars of auto loan-backed securities with below investment grade ratings – in some cases as low as single-B. They are willing to do so in large part because lenders are putting up additional loans as collateral for the bonds, and because credit rating agencies believe that this overcollateralization will insulate investors from expected losses.
Problems at Honor Finance, an Evanston, Ill., lender backed by CIVC Partners, show that this form of credit enhancement can’t cure all ills. In July, both S&P Global Ratings and Kroll Bond Rating Agency downgraded the most subordinate securities issued in a 2016 transaction after Honor lost much of its senior management, stopped originating loans, and resigned as servicer. Losses on collateral for the deal are so high that both rating agencies believe investors are at substantial risk of not being repaid.
Honor wasn’t the first subprime auto lender to run into problems since the financial crisis. At least two others, Summit Financial Corp. and Spring Tree Lending, have folded this year after allegations of fraud or misreported losses caused their banks to withdraw funding. But none of these other lenders had tapped the securitization market for funding, so investors didn’t feel it.
“Pre-crisis, many subprime bonds came with a financial guarantee; they were wrapped with insurance, in addition to overcollateralization,” said Joseph Cioffi, chair of the insolvency, creditors’ rights and financial products practice group at Davis & Gilbert. “Today, there is more reliance on excess collateral.”
He said this is often accompanied by a drift in credit standards.
Certainly, Honor played at the deep end of the subprime auto market, lending to borrowers with FICO scores ranging from 475-650, according to S&P. And nearly a quarter had no FICO score. But many of its lending practices, such as high loan to value ratios (the initial weighted average LTV of the loans Honor securitized was 135.12%) are common in the industry. And it appeared to avoid one of the industry’s riskiest practices, extending the terms of loans in order to lower monthly payments. None of the loans in the 2016 securitization had terms beyond five years, according to rating agency research.
Nevertheless, the transaction raised some eyebrows because, at that time, only more seasoned issuers had been able to issue bonds with such low ratings.
“It was a very bold move,” Cioffi said.
Honor was able to pull this off in part because its management team had individual experience in the subprime auto lending industry and so were not unknown. Co-founders James Collins and Robert DiMeo had worked together for over 20 years, including their stints at another lender, Mercury Finance, where Collins was brought in as COO to lead a restructuring and DiMeo was the vice president of credit.
Moreover, the company had been profitable since 2012.
And investors were desperate for yield and were becoming more comfortable taking on additional risk, thanks to the increased credit enhancements.
“Beginning in late 2016, across all structured products, spreads compressed significantly and issuers began increasing leverage within securitizations by issuing further and further down the capital stack. I don’t think subprime auto was any different,” said Neil Aggarwal, a senior portfolio manager at Semper Capital.
While there was some market turmoil early in 2016, by the time the Honor securitization was issued in December, the markets had recovered and “a full-on grab for yield was taking place,” Aggarwal said. “Much of the ABS sector had rallied back in spread terms, and interest rates were still very low. So a lot of deals that could get done were getting done.”
Both S&P Global Ratings and Kroll Bond Ratings believed that investors in Honor’s auto asset-backeds would continue to receive interest and principal so long as losses stayed within their expectations for 20.5% to 21.5% of the original balance of the collateral over the life of the transaction.
The rating agencies based their views on the fact that the initial overcollateralization of Honor’s transaction was 11%: it was issuing $100 million of bonds backed by $111 million of loans. This meant there would be more interest payment rolling in each month than were needed to pay interest and principal payments on the bonds. These extra funds could be used to pay down additional bond principal, quickly building the overcollateralization to 20.5% of the outstanding bonds. In other words, there would be fewer bonds left outstanding, leaving the remaining bonds better insulated from losses.
That’s not how things turned out.
According to both S&P and Kroll, Honor had a policy of offering borrowers additional time to make payments that was unusually lenient. After this policy was revised, delinquencies and losses started to pile up faster. That meant there wasn’t as much additional cash available to pay down the principal of the bonds. By July, losses had already reached 20%, and overcollateralization had fallen to 13.36%, prompting both S&P and Kroll to downgrade the $8.9 million of BB-rated bonds,
It was the first time S&P had downgraded a subprime auto loan asset-backed since 2002, and the first downgrade of any kind of auto loan ABS since 2011.
Things could get even worse. Honor’s two co-founders and chief financial officer have left the company and Wells Fargo has withdrawn a line of credit Honor relied on to warehouse loans until they could be securitized. This brought new originations to a halt. On July 13, Honor notified the indenture trustee (which is also Wells Fargo) that it intended to resign as servicer. In August, senior noteholders approved the appointment of a successor servicer, a unit of Westlake Financial Services, a subprime lender based in Los Angeles.
A servicing transfer comes with its own risk: A potential disruption in payment collections. Kroll said in July it was concerned that this could result in a majority of borrowers who were currently behind on payments or had obtained an extension to eventually default. When the servicing transfer was approved, the rating agency issued a report saying it was closely monitoring the situation.
S&P has said it expects that losses on the collateral for Honor’s deal could eventually reach 30%.
Problems at Honor have had little impact on demand for subordinated asset-backeds issued by other lenders. They have continued to tap the securitization market for bonds rated both double B and single B. In fact, issuance of single B notes, which were unheard of until this year, had reached some $141 million through June, according to S&P.
Most recently, Westlake completed a $1.1 billion securitization in August that included $62.2 million of single B notes. It was the lender’s third deal of the year, and was upsized from $800 million initially.
In a report published in June, S&P noted that this follows a similar pattern in which demand for higher yield spurs increased issuance of riskier securities, just as the credit cycle is turning.
“This is reminiscent of the mid-1990s when BB rated classes first become popular,” the report states. Issuance of BB rated auto asset-backeds grew from $5.2 million in 1995 to $26.2 million in 1996, and approximately $60 million in 1997, just as the subprime auto loan industry was beginning to unravel.
The rating agency warned that there is no rating history of single B auto bonds, so it's unclear how they might perform in an economic or business downturn.
Lenders aren’t just offloading more of the risk in their deals, they are also loosening underwriting – so there is more risk to unload. Prime and subprime lenders alike are increasingly using features such as longer terms, which lower monthly payments, and high LTVs, which allow borrowers to roll the balance of existing loans into new loans.
Jeremy Acevedo, manager of industry analysis at Edmunds.com, said the extension of loan terms, combined with a propensity to roll over the unpaid balance of old loans “is a recipe for trouble ahead,” and not just for subprime loans, but for loans to prime borrowers as well.
Another factor that is tough on borrowers but good for asset-backed investors is that used- car prices have held firm, and in some cases are still rising.
“This is largely coming from the leasing phenomena,” Acevedo said. “It’s causing a tidal wave of near-new vehicles to hit the market, bringing prices up significantly We’ve never seen this many near-new used cars. Older cars are in shorter supply, and demand is really heavy.”
High used-car prices encourage borrowers to stretch their budgets, though it also reduces losses for investors when a borrower defaults and the vehicle is repossessed.
Aggarwal acknowledged that problems at Honor “highlight some of the embedded risks” in the subprime auto sector, even if he it did not impact demand for the broader market.
“With subprime auto ABS, there’s very little information available about the payment history and creditworthiness of borrowers when compared to other sectors within structured products,” Aggarwal said. “So investors have to base their assessment of risk more heavily on the lender and servicer. And there’s a significant amount of inherent risk in originating and servicing subprime auto loans.” That’s why there is often tiering of these operators that determines how easy it is to sell the securities when something goes wrong.
“Something like the events at Honor definitely creates more caution” for other third- and fourth-tier operators. However, it’s not impacting prices of the top tier of subprime issuers,” he said.
“The structure of subprime auto securities is fantastic; there’s a lot of excess spread to turbo [pay down] bonds, it’s short-dated, and there are a lot of structural protections.” However, liquidity is not always there. “As an investor, you have to evaluate how much spread you require to take at that level of risk.”