Exeter Finance Corp. cleaned up the pool of subprime auto loans backing its latest securitization, driving down the cost of financing compared with its previous deal completed in January.

The triple-A rated, one-year tranche of Exeter Automobile Receivables Trust 2014-2, which priced this week, pays 80 basis points over the eurodollar synthetic forward curve, according to an Interactive Data report. That was 20 basis points less than the senior tranche of Exeter Automobile Receivables Trust 2014-1.

The cheaper funding may reflect the smaller percentage of deep subprime borrowers in the latest deal. Just 33% of the loans had a FICO score of less than 540, down from 36% in the January deal. Borrowers in the latest deal were also a little less underwater on their loans, borrowing 111% of the value of their vehicles, compared with 113% for the January deal. Likewise, the portion of loans with longer terms – as long as six years, decreased to 81.49% from 89.62% in the January deal.   

Exeter is not alone. After several years of competing aggressively on price for loans in an effort to expand their market share, other subprime lenders appear to be tightening their underwriting standards, backing away from some of the weakest borrowers in the process. They are doing so in response to rising delinquencies and losses on the loans in their existing servicing portfolios.

An April report by Moody’s Investors Service cites data from Experian showing that the credit scores of borrowers financing used-car purchases rose in the fourth quarter of 2013 for the first time since 2010. “The progressively weakening performance of recent subprime auto originations might be encouraging some lenders to pull back on lending to riskier borrowers,” the report states.

As a result, interest rates are going up for these riskier borrowers. Between the fourth quarters of 2012 and 2013, the annual percentage rate rose to 14.04% from 13.56% for subprime used vehicle loans and to 8.88% from 8.81% for subprime new vehicle loans. 

It’s notable that Exeter, headquartered in Irving, Texas, is one of the newer subprime lenders to tap the securitization market.  The company, which was acquired by the Blackstone Group in 2011, originates auto loans indirectly through franchised and independent dealerships. Like other new entrants, it has been growing its portfolio very rapidly. Amy Martin, a senior director at Standard & Poor’s auto ABS group, says that, as of March 31, 2014, Exeter’s managed portfolio stood at $2.22 billion, double the size it was a year earlier.

This kind of growth typically comes at the expense of credit quality.  So the improvement in the collateral quality for the latest transaction indicates that the issuer is becoming more selective about the dealers with which it will do business.

The company’s management said that it took steps during the second half of 2013 to tighten its underwriting standards, which includes using credit bureau data to identify and decline borrowers at a greater risk of default and implementing minimum down payment requirements by internal score tiering, according to S&P. It has also discontinued business with the weakest-performing dealers.

“As newer subprime lenders establish dealer relationships, they are able to prioritize which dealers they want to keep and which ones they want to eliminate,” Martin said. “And usually the ones they keep are the dealers whose loans perform relatively well.”

According to Martin, the Exeter portfolio experienced some “modest degradation” in credit quality —total delinquencies increased to 8.90% as of March 31, 2014, from 7.82% a year earlier. Delinquencies have been trending higher than management's expectations since the fourth quarter of 2011.

“The credit performance is below our original expectation, but what we are seeing with Exeter, like many new subprime auto finance companies, is that they were the new kids on the block and initially targeted the deep subprime segment to build their dealer relationships and build scale,” said Martin.  

This increased selectivity has yet to show up in performance; most subprime auto finance securitization issuers started reporting rising delinquencies in their managed portfolios at year-end 2012. In an April 2014 report, S&P said that year-over-year performance continues to weaken for most issuers, with increased annualized net losses and delinquencies in February. Although monthly net losses showed an improvement (the loss rate started retreating in January to 7.16% before dropping to 5.75% in February 2014), year-over-year performance continues to weaken.

“The 5.75% net loss rate for February 2014 is at the highest level observed for this period in the last four years, however, it still remains well below the 8.30% and 9.83% respective levels reached in February 2008 and 2009,” the report states.

Delinquencies rates are also starting to slow, month-after-month after peaking at in December 2013, when the percentage of loans more than 60 days late on payments reached 4.13%. That whe highest level since January 2010, when it was 5.16%, according to S&P. By February of this year, however, they had fallen to 3.10%.

“Over the past few years, there has been a increase in losses but this reflects in part a normalization of loss levels back to where you would expect the losses for the given portion of the market that they are in,” said Rosemary Kelley, a senior director in the consumer ABS group at Kroll Bonds Ratings. “During the crisis there was a big pull back in terms of the origination volume which was due to tighter underwriting standards but also due to lower subprime borrowers opting not to purchase vehicles during that period of time,” said Kelley. “So loans originated in 2010 and early 2011 performed better than historical subprime performance.

The question is, “at what point does that normalization stop and is there deterioration in performance based on more aggressive underwriting standards?”

Not all credit metrics are improving. For example, the weighted average collateral characteristics have slightly weakened in the first quarter of this year compared with 2013. Take loan to value ration: although Exeter’s latest deal had a lower weighted average LTV than in January deal, LTVs across the industry as a whole continue to rise.

According to S&P, the weighted average LTV for subprime has gone up to 117% YTD from a low of 111.8% in 2011, when there were fewer lenders and buying patterns were more conservative..

“When we see higher LTVs, that shows us that it’s becoming a very competitive industry whereby finance companies are willing to pay more and more for these loans in order to be successful at purchasing then from the dealers,” said Martin. In a more competitive lending environment, dealers tend to sell the loans to the finance companies that offer a higher price.  

 A wave of cars coming off-lease will also test the used car market, which affects the recovery values and loss rates on loans in securitizations.  "Right now the market is very strong but we would expected prices to decline in the future as more vehicles come off lease," said Kelley.  This is expected to impact the supply and demand dynamics of the market.

S&P said in a May 21, report that it anticipates used vehicle values to decline this year (as of January month-end they were 0.9% lower than in January 2013, according to the Manheim Used Vehicle Value Index), owing to an increased supply of used vehicles, resulting from higher unit sales for the past three years (new sales are usually accompanied with a trade-in vehicle) and an increase in off-lease vehicle volume.

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